Solutions Manual for International Trade 4th Edition by Robert Feenstra, Alan Taylor by ACADEMIAMILL

Solutions Manual to End-of-Chapter Questions 1 Trade in the Global Economy 1. In this question, you are asked to update the numbers for world trade that are shown in Table 1-1. a. Go to the World Trade Organization’s website at http://www.wto.org, and look for its trade data under “Documents, data and resources: Publications” for the most recent edition of its International Trade Statistics. Find the Excel spreadsheet or PDF document with “Intra- and interregional merchandise trade,” and print out this table. Answer: If you cannot find the website or spreadsheet, use the 2011 table for “Intraand Inter-Regional Merchandise Trade” that appears below to answer the following questions. 11 Intra- and Inter-regional Merchandise Trade, 2011 (Billions of U.S. Dollars) Origin

North America

World $2,923 North America 1,103 South and 181 Central America Europe 480 Commonwealth 43 of Independent States (CIS) Africa 102 Middle East 107 Asia 906

South and Central America $749 201 200

Europe

Destination CIS* Africa

$6,881 382 138

$530 15 8

$538 37 21

119 11

4,667 409

234 154

19 10 189

205 158 922

2 6 110

Middle East

Asia

World

$672 63 18

$5,133 476 169

$17,816 2,282 750

199 12

194 24

639 117

6,612 789

77 38 152

21 110 242

146 660 2,926

594 1,251 5,538

Data from: WTO, International Trade Statistics 2012. b. From this table, what is the total amount of trade within Europe? What percentage of total world trade is this? Answer: The total amount of trade within Europe is $4,667 billion. This is 26.2% of the world total trade. (The total world trade is $17,816 billion. Share = $4,667/17,816 = 26.2%.)

The trade statistics for 2011 were obtained from Table I-4 at: http://www.wto.org/english/res_e/statis_e/its2012_e/its12_world_trade_e.htm.

c. What is the total amount of trade (in either direction) between Europe and North America? Add that to the total trade within Europe, and calculate the percentage of this to the world total. Answer: $(480 + 382) = $862 billion. Adding that to intra-European trade, we obtain 31% of the world total [$(862 + 4667)/$17,816 = 31%]. d. What is the total amount of trade within the Americas (i.e., between North America, Central America, South America, and within each of these regions)? What percentage of total world trade is this? Answer: $(1,103 + 201 + 181 + 200) = $1,685 billion, or 9.5% of the world total ($1,685/17,816 = 9.5%). e. What is the total value of exports from Europe and the Americas, and what percentage of the world total is this? Answer: $(2,282 + 750 + 6,612) = $9,644 billion, or 54.1% of the world total ($9,645/17,816 = 54.1%). f. What is the total value of exports from Asia, and what percentage of the world total is this? Answer: $5,583 billion, which is 31.1% of the world total. g. What is the total value of exports from the Middle East and the Commonwealth of Independent States, 12 and what percentage of the world total is this? Answer: $(789 + 1,251) = $2,040 billion, which is 11.45% of the world total ($2,039/17,816 = 11.45%). h. What is the total value of exports from Africa, and what percentage of the world total is this? Answer: $594 billion, which is 3.3% of the world total i. How do your answers to (b) through (h) compare with the shares of worldwide trade shown in Table 1-1? Answer: The shares computed in (b) through (h) are quite similar to Table 1-1. The numbers won’t change much, as they are one year apart. 2. Explain what each of the following terms means, and describe one example from this chapter where each of these terms is used. a. Bilateral trade balance Answer: Bilateral trade balance is the difference between exports and imports between two countries. For example, the U.S. bilateral trade balance with China has a deficit of more than $200 billion, which means that the value of exports from the United States to China is less than the value imported from China by more than $200 billion. The Commonwealth of Independent States consists of Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan. 12

b. Trade embargo Answer: A trade embargo involves eliminating trade with a particular country or a group of countries. For example, Cuba has been completely cut off from trade with the United States since the embargo was placed in 1961. c. Free trade area Answer: A free trade area is a group of countries that do not have any import tariffs or quotas for trade between them. Some examples of free trade areas include the North American Free Trade Agreement (NAFTA), Trans-Pacific Partnership (TPP), and Transatlantic Trade and Investment Partnership (TTIP). d. Import quota Answer: An import quota is a type of trade restriction that limits the quantity of a good that can be imported. For example, the Multifibre Arrangement (MFA) restricted the amount of nearly every textile and apparel product that was imported to Canada, the European countries, and the United States from China. MFA began in 1974 and was abolished 2005. e. Offshoring Answer: Offshoring refers to relocating a business process, such as a manufacturing process and service process, from one country to another. For example, the increased trade share of capital and consumer goods could be related with offshoring production process overseas in nowadays. 3. Find online press reports dealing with immigration issues in Europe and in the United States. Summarize the issues being discussed in each case. Answer: This is an open question. See below for one example of immigration issues in Europe and the United States. Given that the number of asylum seekers is sharply increasing and the aging population in the European Union (EU), a hot discussion among politicians and scholars is whether government should return to selective immigration. Compared to Europe, the United States has tended to take only small numbers of asylum seekers, relative to each area’s population. But the United States has a more liberal immigration regime. Immigration in the United States is embraced more warmly by the free market right than trade union left. Immigrants contribute to innovation, and do many jobs that native workers refuse. (OECD Observer:

http://www.oecdobserver.org/news/archivestory.php/aid/337/Immigration_in_the_European_Union:_proble m_or_solution_.html)

Work It Out The quotation from Federal Reserve Chairman Ben Bernanke at the beginning of the chapter is from a speech that he delivered in Jackson Hole, Wyoming, on August 25, 2006, titled “Global Economic Integration: What’s New and What’s Not?” The full transcript of the speech is available at https://www.federalreserve.gov/newsevents/speech/bernanke20060825a.htm. Read this speech and answer the following questions: a. List three ways in which international trade today does not differ from the trade that occurred before World War I.

Answer: i) Physical distance is the same. ii) New transportation methods allow for more trade. iii) Governments foster open trade, as well as ﬁnancial flows. iv) Some groups are opposed to free trade. v) The range of goods that are tradable has broadened. b. List three ways in which international trade today does differ from the trade that occurred before World War I. Answer: i) Intra-industry trade has increased. ii) Information and communication technologies permit trade in services. iii) Scale and pace of growth in trade is faster. iv) Core-periphery pattern is no longer relevant. v) Fragmentation of production processes has occurred. vi) Capital markets are more mature, and gross flows are larger.

Trade and Technology: The Ricardian Model

1. In this problem you will use the World Development Indicators (WDI) database from the World Bank to compute the comparative advantage of two countries in the major sectors of gross domestic product (GDP): agriculture, industry (which includes manufacturing, mining, construction, electricity, and gas), and services. Go to the WDI website at http://wdi.worldbank.org, and choose “Online tables,” where you will be using the sections on “People” and on the “Economy.” a. In the “People” section, start with the table “Labor force structure.” Choose two countries that you would like to compare, and for a recent year write down their total labor force (in millions) and the percentage of the labor force that is female. Then calculate the number of the labor force (in millions) who are male and the number who are female. Answer: 2014

Labor Force (million)

Female Labor (%)

Male Labor (million)

Female Labor (million)

France

30.1

15.95

14.15

Thailand

40.1

18.45

21.65

b. Again using the “People” section of the WDI, now go to the “Employment by sector” table. For the same two countries that you chose in part (a) and for roughly the same year, write down the percent of male employment and the percent of female employment in each of the three sectors of GDP: agriculture, industry, and services. (If the data are missing in this table for the countries that you chose in part (a), use different countries.) Use these percentages along with your answer to part (a) to calculate the number of male workers and the number of female workers in each sector. Add together the number of male and female workers to get the total labor force in each sector. Answer: 2011–2014

Agriculture Male % Female %

Industry Male % Female %

Service Male % Female %

France

Thailand

2011–2014 (million)

Agriculture Male Female

Industry Male Female

Service Male Female

France

0.64

0.28

4.95

1.42

10.37

12.45

Thailand

8.12

8.44

4.24

3.90

6.09

9.31

c. In the “Economy” section, go to the table “Structure of output.” There you will find GDP (in $ billions) and the % of GDP in each of the three sectors: agriculture, industry, and services. For the same two countries and the same year that you chose in part (a), write down their GDP (in $ billions) and the percentage of their GDP accounted for by agriculture, by industry, and by services. Multiply GDP by the percentages to obtain the dollar amount of GDP coming from each of these sectors, which is interpreted as the value-added in each sector, that is, the dollar amount that is sold in each sector minus the cost of materials (not including the cost of labor or capital) used in production. Answer: 2014

GDP (billion $)

Agriculture (%)

Industry (%)

Service (%)

France

2829.2

Thailand

404.8

d. Using your results from parts (b) and (c), divide the GDP from each sector by the labor force in each sector to obtain the value-added per worker in each sector. Arrange these numbers in the same way as the “Sales/Employee” and “Bushels/Worker” shown in Table 2-2. Then compute the absolute advantage of one country relative to the other in each sector, as shown on the right-hand side of Table 2-2. Interpret your results. Also compute the comparative advantage of agriculture/industry and agriculture/services (as shown at the bottom of Table 2-2), and the comparative advantage of industry/services. Based on your results, what should be the trade pattern of these two countries if they were trading only with each other?

Answer: ($1000)

France

Thailand

Absolute Advantage France/Thailand Ratio

Service

97.94

13.93

7.03

Industry

84.39

18.4

4.59

Agriculture

61.50

4.89

12.58

Agriculture/ Service

0.63

0.35

Agriculture/ Industry

0.73

0.27

Industry/Service

0.86

1.33

Comparative Advantage

Thailand has a comparative advantage in both Service and Industry. Suppose that a farmer spends 1,000 hours per year in agriculture production. Multiplying the marginal product of an hour of labor in agriculture by 1,000, to obtain the marginal production of labor per year and dividing by the marginal production of labor in Service gives us the opportunity cost of Service. In France, this ratio is 0.63, indicating that $0.63 must be foregone to obtain an extra dollar of sales in Agriculture. In Industry, the ratio is 0.73 in France. These ratios are much smaller in Thailand, only 0.35 for Service and 0.27 for Industry. As a result, Thailand has a lower opportunity cost of both Industry and Service. Therefore, if assuming the two countries are trading only with each other, France will export Agriculture while Thailand will export Service and Industry. 2. At the beginning of the chapter, there is a brief quotation from David Ricardo; here is a longer version of what Ricardo wrote: England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. . . . To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take

place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Suppose that the amount of labor Ricardo describes can produce 1,000 yards of cloth or 2,000 bottles of wine in either country. Then answer the following: a. What is England’s marginal product of labor in cloth and in wine, and what is Portugal’s marginal product of labor in cloth and in wine? Which country has absolute advantage in cloth, and in wine, and why? Answer: In England, 100 men produce 1,000 yards of cloth, so MPLC = 1,000/100 = 10. 120 men produce 2,000 bottles of wine, so MPLW = 2,000/120 =16.6. In Portugal, 90 men produce 1,000 yards of cloth, so MPL*C = 1,000/90 = 11.1. Eighty (80) men produce 2,000 bottles of wine, so MPL*w = 2,000/80 = 25. So Portugal has an absolute advantage in both cloth and wine, because it has higher marginal products of labor in both industries than does England.

b. Use the formula PW/PC = MPLC/MPLW to compute the no-trade relative price of wine in each country. Which country has comparative advantage in wine, and why? Answer: For England, PW/PC = MPLC/MPLW = 10/16.6 = 0.6, which is the notrade relative price of wine (equal to the opportunity cost of producing wine). So the opportunity cost of wine in terms of cloth is 0.6, meaning that to produce 1 bottle of wine in England, the country gives up 0.6 yards of cloth. For Portugal, PW*/PC*= MPLC*/MPLW* = 11.1/25 = 0.4, which is the no-trade relative price of wine (equal to the opportunity cost of producing wine). The no-trade relative price of wine is lower in Portugal, so Portugal has comparative advantage in wine, and England has comparative advantage in cloth. Portugal has comparative advantage in producing wine because it has lower opportunity cost (PW*/PC*= 0.4) than England in the production of wine (PW/PC = 0.6).

3. Suppose that each worker in Home can produce two cars or three TVs. Assume that Home has four workers. a. Graph the production possibilities frontier for Home. Answer: See the following figure.

b. What is the no-trade relative price of cars in Home? Answer: The no-trade relative price of cars at Home is PC/PTV = 3/2 = MPLTV/MPC. It is the slope of the PPF curve for Home. 4. Suppose that each worker in Foreign can produce three cars or two TVs. Assume that Foreign also has four workers. a. Graph the production possibilities frontier for Foreign. Answer: See following figure.

b. What is the no-trade relative price of cars in Foreign? Answer: The no-trade relative price of cars in Foreign is P*C/P*TV = 2/3 = c. Using the information provided in Problem 3 regarding Home, in which good does Foreign have a comparative advantage, and why? Answer: Foreign has a comparative advantage in producing televisions because it has a lower opportunity cost than Home in the production of televisions. 5. Suppose that in the absence of trade, Home consumes two cars and nine TVs, while Foreign consumes nine cars and two TVs. Add the indifference curve for each country to the figures in Problems 3 and 4. Label the production possibilities frontier (PPF), indifference curve (U1), and the no-trade equilibrium consumption and production for each country. Answer: See following figures.

6. Now suppose the world relative price of cars is PC/PTV = 1. a. In what good will each country specialize? Briefly explain why. Answer: Home would specialize in TVs, export TVs, and import cars, whereas the Foreign country would specialize in cars, export cars, and import TVs. The reason is because Home has a comparative advantage in TVs and Foreign has a comparative advantage in cars. b. Graph the new world price line for each country in the figures in Problem 5, and add a new indifference curve (U2) for each country in the trade equilibrium. Answer: See the following figures.

c. Label the exports and imports for each country. How does the amount of Home

exports compare with Foreign imports? Answer: See graph in part (b). The amount of Home TV exports is equal to the amount of Foreign TV imports. In addition, Home imports of cars equal Foreign exports of cars. This is balanced trade, which is an essential feature of the Ricardian model. d. Does each country gain from trade? Briefly explain why or why not. Answer: Both Home and Foreign benefit from trade relative to their no-trade consumption because their utilities are both higher (consumption bundles located on higher indifference curves). Work It Out Answer the following questions using the information given by the accompanying table. Home 4

Foreign 6

Absolute Advantage ?

Number of snowboards produced per hour

Comparative Advantage

Number of bicycles produced per hour

a. Complete the table for this problem in the same manner as Table 2-2. Answer: See previous table. b. Which country has an absolute advantage in the production of bicycles? Which country has an absolute advantage in the production of snowboards? Answer: Foreign has an absolute advantage in both production of bicycles and snowboards, because it is able to produce more in an hour than Home. c. What is the opportunity cost of bicycles in terms of snowboards in Home? What is the opportunity cost of bicycles in terms of snowboards in Foreign? Answer: The opportunity cost of one bicycle is 3/2 snowboards at Home (PB/PS = MPLS/MPLB = 6/4 = 3/2). The opportunity cost of one bicycle is 4/3 snowboards in the Foreign country (PB*/PS* = MPLS*/MPLB* = 8/6 = 4/3). d. Which product will Home export, and which product does Foreign export? Briefly explain why. Answer: The opportunity cost of one bicycle is 3/2 snowboards at Home (PB/PS = MPLS/MPLB = 6/4 = 3/2). The opportunity cost of one bicycle is 4/3 snowboards in the Foreign country (PB*/PS* = MPLS*/MPLB* = 8/6 = 4/3). Home has a smaller opportunity cost producing snowboards than the Foreign country. Home will export snowboards and Foreign will export bicycles.

7. Assume that Home and Foreign produce two goods, TVs and cars, and use the information below to answer the following questions: In the No-Trade equilibrium:

Home WageTV = 12 WageC = ?

Foreign Wage TV = ? Wage*C = 6

MPLTV = 4

MPLC = ?

MPL*TV = ?

MPL*C = 1

PTV = ?

PC = 4

P*TV = 8

P*C = ?

a. What is the marginal product of labor for TVs and cars in Home? What is the notrade relative price of TVs in Home? Answer: MPLC = 3, MPLTV = 4, and PTV/PC = MPLC /MPLTV = 3/4 b. What is the marginal product of labor for TVs and cars in Foreign? What is the no-trade relative price of TVs in Foreign? Answer: MPL*C = 1, MPL*TV = 3/4, and P*TV/P*C = MPL*C/MPL*TV = 4/3 c. Suppose the world relative price of TVs in the trade equilibrium is PTV/PC = 1. Which good will each country export? Briefly explain why. Answer: Home will export TVs and Foreign will export cars because Home has a comparative advantage in TVs whereas Foreign has a comparative advantage in car. Each country will specialize in the goods with lower opportunity cost. d. In the trade equilibrium, what is the real wage in Home in terms of cars and in terms of TVs? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? Answer: Workers at Home are paid in terms of TVs because Home exports TVs. Home is better off with trade because its real wage in terms of cars has increased.

MPLTV = 4 units of TV   or Home wages with trade=  (P /P ) ⋅ MPL = (1) ⋅ 4 = 4 units of car TV  TV C MPLTV = 4 units of TV   or Home wages w/o trade=  (P /P ) ⋅ MPL = (3/4) ⋅= 4 3 units of car TV  TV C

e. In the trade equilibrium, what is the real wage in Foreign in terms of TVs and in terms of cars? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? Answer: Foreign workers are paid in terms of cars because Foreign exports cars. Foreign gains in terms of cars with trade. (PC /PTV ) ⋅ MPL*C = (1) ⋅1 = 1 units of TV  Foreign wages with trade=  or *  MPLC = 1 units of car  * (PC* /PTV* ) ⋅ MPL= (3/4) = ⋅1 3/4 unit of TV C  Foreign wages w/o trade=  or  MPL*C = 1 units of car 

f. In the trade equilibrium, do Foreign’s workers earn more or less than Home’s workers, measured in terms of their ability to purchase goods? Explain why. Answer: Foreign workers earn less than workers at Home in terms of cars because Home has an absolute advantage in the production of cars. Home workers also earn more than Foreign workers in terms of TVs 8. Why do some low-wage countries, such as China, pose a threat to manufacturers in industrial countries, such as the United States, whereas other low-wage countries, such as Haiti, do not? Answer: To engage in international trade, a country must have a minimal threshold of productivity. Countries such as China have the productivity necessary to compete successfully, but Haiti does not. China can enter the world market because it beats other industrial countries with a lower price. Under perfect competition, price is determined by both wage rate and productivity; that is, P = Wage/MPL. So the lower price in China comes from both a low wage rate and high MPL. Haiti has a low wage rate, but also low MPL. So Haiti’s price is not low enough to enter the world market. Answer Problems 9 to 11 using the chapter information for Home and Foreign. 9. a. Suppose that the number of workers doubles in Home. What happens to the Home PPF and what happens to the no-trade relative price of wheat?

Answer: With the doubling of the number of workers in Home, it can now produce 200 = 4 · 50 bushels of wheat if it concentrates all resources in the production of wheat, or it could produce 100 = 2 · 50 yards of cloth by devoting all resources to the production of cloth. The PPF shifts out for both wheat and cloth. The no-trade relative price of wheat remains the same because both MPLW and MPLC are unchanged. b. Suppose that there is technological progress in the wheat industry such that Home can produce more wheat with the same amount of labor. What happens to the Home PPF and what happens to the relative price of wheat? Describe what would happen if a similar change occurred in the cloth industry.

Answer: Because the technological progress is only in the wheat industry, Home’s production of cloth remains the same if it devotes all of its resources to producing cloth. If instead Home produces only wheat, it is able to produce more wheat using the same amount of labor. Home’s PPF shifts out in the direction of wheat production. Recall that the relative price of wheat is given by PW/PC = MPLC/MPLW. With the technological progress in wheat, the marginal product of labor in the wheat production increases. Thus, the relative price of wheat decreases. As shown in the graph, the relative price of wheat drops from 1/2 to 1/4. If instead the technological progress is in the cloth industry, we would have the opposite results. Home’s PPF would shift out in the direction of cloth production and the relative price of wheat would increase. 10. a. Using Figure 2-5, show that an increase in the relative price of wheat from its 2 world relative price of 3 will raise Home’s utility.

Answer: The increase in the relative price of wheat from its international equilibrium of 2/3 allows Home to consume at a higher utility, such as at point D. b. Using Figure 2-6, show that an increase in the relative price of wheat from its 2 world relative price of 3will lower Foreign’s utility. What is Foreign’s utility when the world relative price reaches 1, and what happens in Foreign when the world relative price of wheat rises above that level?

Answer: The increase in the relative price of wheat from its international 2 equilibrium of 3 lowers Foreign’s utility to U*3 with consumption at D*. When the international price reaches 1, it becomes the same as Foreign’s no-trade relative price of wheat. Thus, Foreign consumes at point A*, the no-trade equilibrium. If the international price rises above 1, then it would be greater than Foreign’s no-trade relative price of wheat. In this case, Foreign would switch to exporting wheat instead of exporting cloth. The world price line now moves inside the PPF, which will lower the no trade relative price of wheat. 11. (This is a harder question.) Suppose that Home is much larger than Foreign. For example, suppose we double the number of workers in Home from 25 to 50. Then, suppose that Home is willing to export up to 100 bushels of wheat at its no-trade price 1 of PW/PC = 2, rather than 50 bushels of wheat as shown in Figure 2-11. In the following figure, we draw a new version of Figure 2-11, with the larger Home. a. From this figure, what is the new world relative price of wheat (at point D)? Answer: The intersection of the Foreign imports and Home exports gives the new 1 international equilibrium relative price of wheat, which is 2.

b. Using this new world equilibrium price, draw a new version of the trade equilibrium in Home and in Foreign, and show the production point and consumption point in each country. 1 Answer: The international price of 2 is the same as Home’s no-trade relative price of wheat. Home would consume at point A and produce at point B´. The difference between these two points gives Home exports of wheat of 80 units. (Notice that workers earn equal wages in the two industries, so production can occur anywhere along the PPF.)

Because the international price of 1/2 is lower than Foreign’s no-trade relative price of wheat, Foreign is able to consume at point D*, which gives higher gains from trade than at point C*.

c. Are there gains from trade in both countries? Explain why or why not. Answer: The Foreign country gains a lot from trade, but the home country neither gains nor loses: Its consumption point A is exactly the same as what it would be in the absence of trade. This shows that in the Ricardian model, a small country can gain the most from trade, whereas a large country may not gain (although it will not lose) because the world relative price might equal its own no-trade relative price. So the large country does not see a terms of trade (TOT) gain. This special result will not arise in other models that we study, but illustrates how being small can help a country on world markets! 12. Using the results from Problem 11, explain why the Ricardian model predicts that Mexico would gain more than the United States when the two countries signed the North American Free Trade Agreement, establishing free trade between them. Answer: The Ricardian model predicts that Mexico would gain more than the United States when the two countries join the regional trade agreement because relative to the United States in terms of economic size, Mexico is a small country. For the United States, the world price of its exports is similar to the domestic price. Thus, there is not much TOT gain. But for Mexico, the world price is much higher than the domestic price of its exports, so Mexico sees a big TOT improvement.

3 Gains and Losses from Trade in the Specific-Factors Model 1. In the chapter, we learned that workers displaced by import competition are eligible for compensation through the Trade Adjustment Assistance program. Firms are also eligible for support through Trade Adjustment Assistance for Firms, a federal program that provides financial assistance to manufacturers affected by import competition. Go to http://www.taacenters.org to read about this program, then answer the following: a. Describe the criteria a firm has to meet to qualify for benefits. Answer: According to the website, manufacturers are qualified to receive benefits from the TAA if imports have contributed to declines in their employment and sales or production.

b. What amount of money is provided to firms, and for what purpose? Describe one of the “success stories,” in which a firm used financial assistance to improve its performance. Answer: Under the “50/50 cost sharing” program, the TAA pays up to $75,000 for projects to improve a manufacturer’s competitiveness. The funds go toward the cost of hiring industry experts, including consultants, engineers, and designers for projects. c. Provide an argument for and an argument against the continued funding of this federal program. Answer: Opponents of TAA would argue that the program is costly. The following figure shows the total expenditures of the program from 1995 to 1999, when more than half of the cost was administrative and operations related. Proponents of TAA would draw on the positive effect the assistance program has on the manufacturing industry and local economy.

2. Why is the specific-factors model referred to as a short-run model? Answer: It is a short-run model because land and capital are specific to a particular sector and only labor is mobile between the sectors. In the long run, all factors of production will be mobile across sectors. 3. Figure 3-7 presents wages in the manufacturing and services sectors for the period 1974 to 2014. Is the difference in wages across sectors consistent with either the Ricardian model studied in Chapter 2 or the specific-factors model? Explain why or why not. Answer: The difference in wages across the sectors implies that the theoretical assumption of equalized earnings between the different industries is a simplification of the Ricardian and specific-factors models. 4. In the gains from trade diagram in Figure 3-3, suppose that instead of having a rise in the relative price of manufactures, there is a fall in that relative price. a. Starting at the no-trade point A in Figure 3-3, show what would happen to production and consumption. Answer:

As seen in this diagram, a fall in the relative price of manufactures is shown by the smaller slope (in absolute value) of the international price line. The country produces at point B, at which the international price line intersects its PPF. The higher relative price of agriculture attracts workers into that sector such that the output of agriculture increases and the output of manufactured goods decreases. Now the highest level of utility is achieved where the highest possible indifference curve is tangent to the new price line (at C). The increase in utility signified by the higher indifference curve is a measure of gains from trade. b. Which good is exported and which is imported? Answer: The decrease in the relative price of manufactures in the trade equilibrium (compared with autarky) also means that the country is importing manufactured goods and exporting agricultural goods. c. Explain why the overall gains from trade are still positive. Answer: Overall gains from trade are still positive because the country is able to sell agriculture at a higher price and buy manufactured goods at a lower price than it could have in autarky. The fact that the relative price (of manufactured goods) fell with trade indicates that the foreign country’s autarky relative price was lower. That is, in this case the country has a comparative advantage in agriculture. In Figure 3-3, the case illustrated is one in which the country has a comparative advantage in manufacturing goods and thus their export leads to an increase in their relative price. 5. Starting from equilibrium in the specific-factors model, suppose the price of manufactured goods falls so that wages fall from W′ to W in Figure 3-5. a. Show that the percentage fall in the wage is less than the percentage fall in the price of manufacturing so that the real wage of labor in terms of manufactured goods goes up. Answer:

As seen in the diagram, both the price of manufactured goods and the wages decrease. The key to this exercise is to realize that the vertical distance of the decrease in wage is less than the vertical distance of ∆PM* MPLM. Therefore: ∆PM* MPLM > ∆W where ∆W represents the change in wage. Dividing both sides by the initial wage (W′ = PM* MPLM): ∆PM/PM > ∆W/W This is the desired result: The percentage fall in the wage is less than the percentage fall in the price of manufacturing so that the real wage of labor in terms of manufactured goods goes up. b. What happens to the real wage of labor in terms of agriculture? Answer: Because the wage decreases and the price of agricultural goods remains the same, the amount of agricultural goods that can be bought by labor decreases. That is, real wage decreases in terms of agriculture. c. Are workers better off, worse off, or is the outcome ambiguous? Answer: Because the real wage increases with respect to manufactured goods and decreases with respect to agriculture, the outcome will be ambiguous for workers. For some, who prefer to purchase a lot of agriculture, the price change means an overall loss in terms of how much they can buy. Others, who prefer to buy mainly manufactured goods, gain in terms of how much they can buy. Work It Out Use the following information to answer the questions below:

Manufacturing: Agriculture:

Sales revenue = PM · QM = 150 Payments to labor = W · LM = 100 Payments to capital = RK · K = 50 Sales revenue = PA · QA = 150 Payments to labor = W · LA = 50 Payments to land = RT · T = 100

Holding the price of manufacturing constant, suppose the increase in the price of agriculture is 20% and the increase in the wage is 10%. a. Determine the impact of the increase in the price of agriculture on the rental on land and the rental on capital. Answer: Rental on land can be calculated as follows:

∆RT (∆PA /PA ) ⋅ PAQA − (∆W /W ) ⋅ WLA = RT ⋅ T RT 20% ⋅150 − 10% ⋅ 50 ∆RT = 25% = 100 RT Recalling that the price of manufacturing remained constant, we get the rental on capital as

0 ⋅ QM − ∆W ⋅ LM K ∆W  W ⋅ LM  ∆R K   = − W  RK ⋅ K  RK

∆RK =

∆RK  100  = − 10% ⋅   = −20% . RK  50 

b. Explain what has happened to the real rental on land and the real rental on capital. Answer: Because of the 20% increase in the price of agriculture, the real rental on land rose, whereas the real rental on capital fell. Therefore, landowners are better off because the percentage increase in the rental on land is greater than the percentage increase in the price of agriculture, whereas the price of manufacture is constant. Capital owners are worse off in terms of their ability to purchase both manufacture and agriculture because the rental to capital has fallen.

W /W < PA < ∆RT /RT , for an increase in PA ∆RK /RK < 0 < ∆         

Real rental on capital falls

Change in the real wage is ambigous

Real rental on land rises

6. If, instead of the situation given in the Work It Out problem, the price of manufacturing were

to fall by 20%, would landowners or capital owners be better off? Explain. How would the decrease in the price of manufacturing affect labor? Explain. Answer: Capital owners would be worse off since the decrease in rental on capital (40%) is greater than the drop in the price of manufacturing (20%). Landowners would be better off in terms of manufacturing goods as the rental on land decreases less (5%) than the drop in the price of manufacturing, and they would be worse off in terms of agriculture. The effect on labor is ambiguous because while the percentage of wage decrease is less than the percentage fall in the price of manufacturing, labor loses in terms of their availability to purchase agriculture. The rental on capital is found by calculating the following:

(∆PM / PM ) ⋅ PM QM − (∆W / W ) ⋅ WLM ∆RK = RK RK ⋅ K

∆RK − 20% ⋅150 − 10% ⋅100 = −40% = 100 RK although the rental on land is ∆RT =

∆RT RT

0 ⋅ Q A − ∆W ⋅ L A T ∆W  W ⋅ L A    = − W  RT ⋅ T 

∆RT  50  = − 10% ⋅   = −5% RT  100  Putting it together we get ∆𝑅𝑅𝐾𝐾 /𝑅𝑅𝐾𝐾 < ∆𝑃𝑃𝑀𝑀 /𝑃𝑃𝑀𝑀 < ∆𝑅𝑅𝑇𝑇 /𝑅𝑅𝑇𝑇 < 0 < ∆𝑊𝑊/𝑊𝑊, for a decrease in 𝑃𝑃𝑀𝑀 .

Real rental on capital falls

Real rental on land decreases

Change in real wage is ambiguous

7. Read the article by Grant Aldonas, Robert Lawrence, and Matthew Slaughter, available online at: https://www.hks.harvard.edu/fs/rlawrence/fsf_adjustment_assistance_plan.pdf. Then answer the following questions. a. What is the name of the new program that these authors propose, and from what three programs in the United State would it combine elements? Answer: The authors propose the Adjustment Assistance Program (APP), which combines the best element of UI, TAA, and training programs by the Workforce Investment Act (WIA).

b. What is the authors’ specific proposal for wage-loss insurance? Answer: They propose the immediate adoption of similar new wage-loss insurance program proposed in the Worker Empowerment Act of 2007, but with eligibility for all workers aged 45 and older. c. What is their specific proposal for health insurance? Answer: They propose reducing the gap in health insurance by having the UI system pay for any COBRA health insurance payment incurred while receiving UI income benefits. d. What is their specific proposal for giving workers access to savings? Answer: They propose providing new relief from penalties for withdraws from common tax-preferred saving accounts to allow workers to tap their own savings to assist in their transition e. Would the program they propose depend on a worker losing his or her job because of trade competition or a shift of production facilities overseas? Answer: They propose to eliminate TAA’s requirement that a worker be required to shown nexus to trade or shift of production overseas as the basis for providing assistance. Instead, they would make a training stipend available to every UI-eligible worker f.

What would their proposed program cost annually, and how does that compare with the annual cost of the Trade Adjustment Assistance program? Answer: The total annual cost of the new programs would be about $22 billion: $10 billion for the health insurance program; $5 billion for tax-related supports for education, training, and relocation; and $7 billion for the wage-loss insurance. The total annual cost would be more than 20 times the resources currently spent on TAA.

8. In the specific-factors model, assume that the price of agricultural goods decreases while the price of manufactured goods is unchanged (ΔPA/PA < 0 and ∆PM/PM = 0). Arrange the following terms in ascending order: ∆RT/RT

∆RK/RK

∆PA/PA

∆PM/PM

∆W/W

Hint: Try starting with a diagram like Figure 3-5, but change the price of agricultural goods instead. Answer: It helps to separate this exercise into two parts. The first part is to arrange the percentage changes in wages and goods prices. This part is similar to problem 4 except that now it is the price of agriculture that is decreasing. By similar logic, the percentage change in the price of agricultural goods is larger than the percentage change in wage, which in turn is larger than the percentage change in the price of manufactured goods (zero). Thus, 0 = ∆PM/PM < ∆W/W < ∆PA/PA For the second part, adding the percentage changes in specific-factors rental rates, recall that in this model, although the real return to labor is ambiguous (which means that more agricultural products but fewer manufactured goods can be purchased by labor), the real return to capital and land can both be determined and move in opposite directions. The

general rule for the specific-factors model is that a decrease in the relative price of an industry leads to a real loss of the factor specific in that industry, and a real return to the specific factor in the other industry. This means that the percentage change in losses to land is greater than both price changes and that the percentage change in returns to capital is greater than both price changes, which is equivalent to saying that fewer of both goods can be purchased by landowners, although more of both goods can be purchased by capital owners, respectively. ΔRK/RK < ΔPM/PM < ΔW/W < ΔPA/PA < ΔRT/RT 9. Suppose two countries, Canada and Mexico, produce two goods: timber and televisions. Assume that land is specific to timber, capital is specific to televisions, and labor is free to move between the two industries. When Canada and Mexico engage in free trade, the relative price of televisions falls in Canada and the relative price of timber falls in Mexico. a. In a graph similar to Figure 3-5, show how the wage changes in Canada due to a fall in the price of televisions, holding constant the price of timber. Can we predict that change in the real wage?

Answer: As shown by the following figure, real wage falls but by less than the percentage decrease in the price of televisions. b. What is the impact of opening trade on the rentals on capital and land in Canada? Can we predict that change in the real rentals on capital and land? Answer: Because capital is specific to the television sector, the drop in the relative price of televisions will lead to a fall in the rental on capital. With Canada exporting timber, rental on land will rise because land is specific to the timber industry.

c. What is the impact of opening trade on the rentals on capital and land in Mexico? Can we predict that change in the real rentals on capital and land? Answer: Through the exports of televisions, the relative price of televisions will rise in Mexico, which will lead to an increase in the rental on capital. By contrast, the rental on land will fall. d. In each country, has the specific factor in the export industry gained or lost and has the specific factor in the import industry gained or lost? Answer: In both cases, the specific factor in the export industry (i.e., land in Canada and capital in Mexico) gained, whereas the factor specific to the import industry (i.e., capital in Canada and land in Mexico) loses when the two countries engage in trade. 10. Home produces two goods, computers and wheat, for which capital is specific to computers, land is specific to wheat, and labor is mobile between the two industries. Home has 100 workers and 100 units of capital but only 10 units of land. a. Draw a graph similar to Figure 3-1 with the output of wheat on the vertical axis and the labor in wheat on the horizontal axis. What is the relationship between the output of wheat and the marginal product of labor in the wheat industry as more labor is used? Answer: See the following graph.

As more labor is added to the production of wheat, the marginal product of labor declines so that although the output of wheat continues to increase, the output is increasing at a decreasing rate. b. Draw the production possibilities frontier for Home with wheat on the horizontal axis and computers on the vertical axis. Answer: See the following graph.

c. Explain how the price of wheat relative to computers is determined in the absence of trade. Answer: In the absence of international trade, the relative price of wheat is the slope of the line tangent to the PPF and Home’s indifference curve. At this tangency, wages are equal in wheat and computer industries. d. Reproduce Figure 3-4 with the amount of labor used in wheat, measuring from left to right along the horizontal axis, and the amount of labor used in computers moving in the reverse direction. Answer: See graph below.

e. Assume that due to international trade, the price of wheat rises. Analyze the effect of the increase in the price of wheat on the allocation of labor between the two sectors. Answer:

The increase in the price of wheat shifts the PW · MPLW curve upward to PW′ · MPLW so

that the new equilibrium is at point B. The amount of labor used in wheat increases from 0WL to 0WL′, although the amount of labor devoted to computers decreases from 0CL to 0CL′. Although the wage rises from W to W′, the increase is less than the vertical shift of the PW · MPLW curve given as ∆PW · MPLW. 11. Similar to Home in Problem 10, Foreign also produces computers and wheat using capital, which is specific to computers; land, which is specific to wheat; and labor, which is mobile between the two sectors. Foreign has 100 workers and 100 units of land but only 10 units of capital. It has the same production functions as Home. a. Will the no-trade relative price of wheat be higher in Home or in Foreign? Explain why you expect this outcome. Answer: The no-trade relative price of wheat will be higher in Home than Foreign because Foreign has more units of land relative to Home. In other words, with more capital available for labor than land, the marginal product of labor in wheat is lower than the marginal product of labor in computers at Home. Because wages are equalized across the sector, price must be higher in the wheat industry: PW · MPLW = PC · MPLC The situation would be opposite for the foreign country, which has more land than capital. In this case, the price of capital is higher relative to the price of wheat without trade.

b. When trade is opened, what happens to the relative price of wheat in Foreign and to the relative price of wheat in Home? Answer: When the two countries engage in trade, Home will export computers, so the relative price of wheat decreases at Home, whereas Foreign will export wheat, which will increase the relative price of wheat in Foreign.

c. Based on your answer to (b), predict the effect of opening trade on the rental on land in each country, which is specific to wheat. What about the rental on capital, which is specific to computers? Answer: With Home exporting computers, the rental on capital will increase while the rental on land will decrease. Because Foreign exports wheat, landowners will experience an increase in the rental on land, whereas capital owners will lose because of the decrease in the rental on capital.

4 Trade and Resources: The Heckscher–Ohlin Model 1. In this problem you will learn how to download data for U.S. export and imports for highly disaggregated products. Supposes that you are hired by a company that wants to start exporting the product it already sells in the United States. You are asked to find out how much is already sold abroad by other U.S. firms and to which countries. To answer this question, you can access the “Trade Stats Express” database at the International Trade Administration, U.S. Department of Commerce. U.S. Exports and Imports for 2014 HS Code 09 0901 0902 0904 0905 0910 09 0901 0902 0904 0905 0910

Product Coffee, Tea, Mate, and Spices Coffee Tea Pepper Vanilla Beans Ginger, Saffron, Turmeric, Thyme, Bay Leaves, etc. Coffee, Tea, Mate, and Spices Coffee Tea Pepper Vanilla Beans Ginger, Saffron, Turmeric, Thyme, Bay Leaves, etc.

Region or Country

Export ($ thousands)

Import ($ thousands)

Africa

3,666

356,399

Africa Africa Africa Africa

209 291 1,794 0

225,090 34,781 0 74,809

Africa

1,235

9,359

Kenya

52,966

Kenya Kenya Kenya Kenya

12 0 0 0

43,692 9,260 0 0

Kenya

a. Start at the webpage http://www.trade.gov/, and find Trade Stats Express under the Data & Analysis tab. Choose National Trade Data, and Product Profiles of U.S. Merchandise Trade with a Selected Market. You will be asked to select a Region or Trade Partner, to select Export, Imports, or Trade Balance, and then to select a Product. The method of keeping track of products is called the Harmonized System (HS). On this page, the HS codes for products can have 2 digits or 4 digits, so choose 4 digits. Change the product from HS-total to any particular product that you find interesting out of the 99 HS codes that are shown, from HS 01 to HS 99. For the product that you have selected, choose a region of the world, and write down in a table the exports to that region of the 2-digit and detailed 4digit products that are shown (see an example for HS 09 in the table). Answer: The argument depends on the chosen countries and the trade pattern within the United States. The below argument is an example based on the table provided.

Because the United States is relatively abundant in skilled labor and scarce in unskilled labor, as predicted by the Heckscher–Ohlin model, the United States imports unskilled-labor-intensive goods such as the ones listed in the table. One exception is pepper, whose production may depend on machines that are abundant in the United States. b. Repeat the same exercise for the imports to the United States from that region for the 2-digit and detailed 4-digit products that are shown (see table on the previous page). Answer: Answers will vary. c. Now choose at least one specific country in the region that you have chosen, and write down the U.S. exports and imports for the same 2-digit and 4-digit HS products (see table on the previous page). Answer: Answers will vary. d. Do you think that the U.S. exports and imports for this region/country/products you have chosen support the predictions of the Heckscher–Ohlin theorem? Explain why or why not. Do you think that there is potential for the U.S. firm that hired you to begin exporting these products? Explain. Answer: Answers will vary. 2. This problem uses the Heckscher–Ohlin model to predict the direction of trade. Consider the production of handmade rugs and assembly line robots in Canada and India. a. Which country would you expect to be relatively labor-abundant, and which is capital-abundant? Why? Answer: Given Canada’s relatively small population (approximately 30 million compared with more than 1 billion in India) and level of development, it is a safe assumption that 𝐿𝐿𝐶𝐶𝐶𝐶𝐶𝐶 ⁄𝐾𝐾𝐶𝐶𝐶𝐶𝐶𝐶 < 𝐿𝐿𝐼𝐼𝐼𝐼𝐼𝐼 ⁄𝐾𝐾𝐼𝐼𝐼𝐼𝐼𝐼 . That is, there is more capital per worker in Canada, making it capital-abundant compared with India. Similarly, India would be labor-abundant. b. Which industry would you expect to be relatively labor-intensive, and which is capital-intensive? Why? Answer: Given the amount of capital required to produce robots and the amount of labor required to produce rugs, one would expect that 𝐿𝐿𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 ⁄𝐾𝐾𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 < 𝐿𝐿𝑅𝑅𝑅𝑅𝑅𝑅 ⁄𝐾𝐾𝑅𝑅𝑅𝑅𝑅𝑅 , making robots capital intensive and rugs labor intensive.

c. Given your answers to (a) and (b), draw production possibilities frontiers for each country. Assuming that consumer preferences are the same in both countries, add indifference curves and relative price lines (without trade) to your PPF graphs. What do the slopes of the price lines tell you about the direction of trade?

Canada’s no-trade production and consumption of robots and rugs corresponds to a relative price of robots that is lower than that in India. This is shown by the flatter-sloped relative price line in Canada. d. Allowing for trade between countries, redraw the graphs and include a “trade triangle” for each country. Identify and label the vertical and horizontal sides of the triangles as either imports or exports. Answer: See the following figures.

e. Using the PPF graphs from (c) and relative prices under autarky and trade, explain how both countries gain from trade? Answer: See figures below. The dashed lines represent the budget line and obtained utility under autarky, while solid lines are for free trade. Under free trade, both countries reach the indifference curve with higher utility.

3. Leontief’s paradox is an example of testing a trade model using actual data observations. If Leontief had observed that the amount of labor needed per $1 million of U.S. exports was 100 person-years instead of 182, would he have reached the same conclusion? Explain. Answer: If the amount of labor required for $1 million of U.S. exports were 100 person-years instead of 182, then the capital/labor ratio for exports would have been $25,500 per person. Because this is larger than the corresponding ratio for imports, this test would have provided support for the Heckscher–Ohlin theorem. That is, the United States (which was assumed to be capital-abundant in both cases) would have been shown to export capital-intensive goods. In actuality, however, Leontief’s test showed exactly the opposite. Work It Out Suppose that there are drastic technological improvements in shoe production in Home such that shoe factories can operate almost completely with computer-aided machines. Consider the following data for the Home country: Computers:

Shoes:

Sales revenue = 𝑃𝑃𝑐𝑐 𝑄𝑄𝑐𝑐 = 100 Payments to labor = 𝑊𝑊𝑊𝑊𝑐𝑐 = 50 Payments to capital = 𝑅𝑅𝑅𝑅𝑐𝑐 = 50 Percentage increase in the price = ∆𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑐𝑐 = 0% Sales revenue = 𝑃𝑃𝑠𝑠 𝑄𝑄𝑠𝑠 = 100 Payments to labor = 𝑊𝑊𝑊𝑊𝑠𝑠 = 10 Payments to capital = 𝑅𝑅𝑅𝑅𝑠𝑠 = 90 Percentage increase in the price = ∆𝑃𝑃𝑠𝑠 ⁄𝑃𝑃𝑠𝑠 = 40%

a. Which industry is capital-intensive? Is this a reasonable question, given that some industries are capital-intensive in some countries and labor-intensive in others? Answer: 𝑊𝑊𝑊𝑊𝑐𝑐 ⁄𝑅𝑅𝑅𝑅𝑐𝑐 > 𝑊𝑊𝑊𝑊𝑠𝑠 ⁄𝑅𝑅𝑅𝑅𝑠𝑠 (and thus 𝐿𝐿𝑐𝑐 ⁄𝐾𝐾𝑐𝑐 > 𝐿𝐿𝑠𝑠 ⁄𝐾𝐾𝑠𝑠 ) implies that shoes are capital-intensive. This is certainly possible as shown in the New Balance

application. In reality, shoes are labor-intensive in India with different production technology. This is factor intensity reversal. b. Given the percentage changes in output prices in the data provided, calculate the percentage change in the rental on capital. Answer: For computers: ∆𝑅𝑅⁄𝑅𝑅 = [(∆𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑐𝑐 )𝑃𝑃𝑐𝑐 𝑄𝑄𝑐𝑐 − (∆𝑊𝑊 ⁄𝑊𝑊 )𝑊𝑊𝑊𝑊𝑐𝑐 ]⁄𝑅𝑅𝑅𝑅𝑐𝑐 = [(0%)(100) − (∆𝑊𝑊 ⁄𝑊𝑊 )(50)]⁄50 = −(∆𝑊𝑊 ⁄𝑊𝑊 ) ⁄ For shoes: ∆𝑅𝑅 𝑅𝑅 = [(∆𝑃𝑃𝑠𝑠 ⁄𝑃𝑃𝑠𝑠 )𝑃𝑃𝑠𝑠 𝑄𝑄𝑠𝑠 − (∆𝑊𝑊 ⁄𝑊𝑊 )𝑊𝑊𝑊𝑊𝑠𝑠 ]⁄𝑅𝑅𝑅𝑅𝑠𝑠 = [(40%)(100) − (∆𝑊𝑊 ⁄𝑊𝑊 )(10)]⁄90 = 40⁄90 − (∆𝑊𝑊 ⁄𝑊𝑊 )(10⁄90) Substituting the computer equation into the shoes equation: ∆𝑅𝑅⁄𝑅𝑅 = 40⁄90 + (∆𝑅𝑅⁄𝑅𝑅 )(10⁄90) This implies: ∆𝑊𝑊 ⁄𝑊𝑊 = − ∆𝑅𝑅⁄𝑅𝑅 = −50%

c. How does the magnitude of this change compare with that of labor? Answer: As seen in the percentage change calculation for the rental of capital in the shoe industry, the magnitudes of the changes are equal (with opposite sign). d. Which factor gains in real terms, and which factor loses? Are these results consistent with the Stolper–Samuelson theorem? Answer: Because the increase in capital returns (+50%) exceeds the price changes in both industries, capital gains in real terms. Similarly, because there is a decrease in wage (−50%) and the prices of the outputs stayed the same for computers or increased for shoes, labor loses in real terms. This is consistent with the Stolper–Samuelson theorem: In the long run, when all factors are mobile, an increase in the relative price of a good will cause the real earnings of labor and capital to move in opposite directions, with a rise in the real earnings of the factor used intensively in the industry whose relative price went up and a decrease in the real earnings of the other factor. 4. Using the information in the chapter, suppose Home doubles in size, while Foreign remains the same size. Show that an equal proportional increase in capital and labor in Home will change the relative price of computers, wage, rental on capital, and the amount traded but not the pattern of trade. Answer: An equal proportional increase in Home’s capital and labor does not change its relative factor endowments, so the labor/capital ratio is unchanged. With constant factor prices, your graph should show that the no-trade equilibrium doubles. Further, the no-trade equilibrium in Foreign is unaffected because its size remained unchanged. At the original world relative price of computers, the quantity exported by Home exceeds the quantity Foreign wants to import, leading to a drop in the relative price. The lower free-trade relative price of computers decreases the rental on capital. However, labor is better off in real terms as a result of the decrease in the relative price of computers from free trade. The pattern of trade remains the same, although

the amount traded has increased. The pattern of trade is consistent with the Heckscher–Ohlin theorem. Despite the proportional increase in its endowments, Home is still capital-abundant, and it continues to export capital-intensive goods.

5. Using a diagram similar to Figure 4-12, show the effect of a decrease in the relative price of computers in Foreign. What happens to the wage relative to the rental? Is there an increase in the labor–capital ratio in each industry? Explain. Answer: With free trade the labor-abundant Foreign country will increase production of the labor-intensive good (shoes), leading to a rightward shift of the relative demand curve from 𝑅𝑅𝑅𝑅1∗ to 𝑅𝑅𝑅𝑅2∗ . At the new equilibrium point 𝐵𝐵 ∗ , computers are weighted less, a fall in (𝐾𝐾∗𝑐𝑐 ⁄𝐾𝐾∗ ), whereas the shoe industry is weighted more, a rise in (𝐾𝐾∗𝑠𝑠 ⁄𝐾𝐾∗ ). As a result of the rise in the relative demand for labor in the shoe industry, the relative wage increases, which in turn lowers the labor/capital ratio in both industries.

6. Suppose when Japan opens to trade, it imports rice, a labor-intensive good. a. According to the Heckscher–Ohlin theorem, is Japan capital-abundant or laborabundant? Briefly explain. Answer: Japan is capital-abundant because it imports the labor-intensive good. b. What is the impact of opening trade on the real wage in Japan? Answer: Japan will specialize in the capital-intensive product, which will lead to an increase in the relative demand for capital in the capital-intensive industry. This causes an increase in the relative rent. The higher relative rent cuts the number of capital hired per unit of labor in the capital-intensive industry, thereby decreasing the capital/labor ratio. By the law of diminishing returns, the decrease in the capital/labor ratio leads to an increase in the marginal product of capital in both industries. Thus, the real rent will increase in Japan following trade. c. What is the impact of opening trade on the real rental on capital? Answer: The real rental on capital will increase because the world relative price of rice is lower than Japan’s no-trade relative price. More specifically, the marginal product of capital increases, so the real rental on capital rises. Based on the Stolper– Samuelson theorem, the abundant factor gains from trade, whereas the scarce factor loses from trade. Japan is labor-scarce and imports labor-intensive goods, so the real rental on capital increases as a result of trade. d. Which group (capital owner or labor) would support policies to limit free trade? Briefly explain. Answer: The labor group will support policies to limit free trade because they

suffer a loss due to the decrease in the relative price of rice when Japan engages in trade. 7. In Figure 4-3, we show how the movement from the no-trade equilibrium point A to a trade equilibrium at a higher relative price of computers leads to an upward-sloping export supply, from points A to D in panel (b). a. Suppose that the relative price of computers continues to rise in panel (a), and label the production and consumption points at several higher prices. Answer: See the following figure.

b. In panel (b), extend the export supply curve to show the quantity of exports at the higher relative prices of computers. Answer: Refer to the following diagram. At the no-trade price of (𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑠𝑠 ) 𝐴𝐴 = 0.5, Home exports 0 units of computers, which is the starting point for the Home export supply curve in panel (b). As the world relative price of computers rises, the exports of computers initially must rise on the export supply curve, as illustrated by Home’s exports of 10 units when the world price is (𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑠𝑠 )𝑊𝑊1 = 1, with production at B1 and consumption at C1. But for higher prices, it is possible that the export supply curve bends backward, as illustrated by the world price of (𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑠𝑠 )𝑊𝑊2 = 1.5, where the export supply is less than 10 units, with production at B2 and consumption at C2. At these points, consumption of computers is 30 units and production is below 40 units, say 39 units, so exports are 9 units. Ultimately, at the corner solution, the world relative price of computers will be completely vertical, meaning the 𝑃𝑃𝑐𝑐 ⁄𝑃𝑃𝑠𝑠 = infinity.

c. What happens to the export supply curve when the price of computers is high enough? Can you explain why this happens? Hint: An increase in the relative price of a country’s export good means that the country is richer because its terms of trade have improved. Explain how that can lead to fewer exports as their price rises. Answer: As the world-relative price for computers rises, this is a terms-of-trade gain for the Home country, which exports computers. From the point of view of Home consumers, it is like a rise in income, so they consume more of both computers and shoes (the income effect). On the other hand, the rise in the relative price of computers leads them to substitute away from this good (the substitution effect). When the income effect dominates the substitution effect, as will occur for sufficiently high increases in the terms of trade, then exports of computers will fall due to increased Home demand. 8. On March 2, 2013, Tajikistan successfully negotiated terms to become a member of the World Trade Organization. Consequently, countries such as those in western Europe are shifting toward free trade with Tajikistan. What does the Stolper– Samuelson theorem predict about the impact of the shift on the real wage of lowskilled labor in western Europe? In Tajikistan? Answer: According to the Stolper–Samuelson theorem, the real wage of unskilled labor in western Europe will experience a decrease in real earnings because western Europe is skilled-abundant relative to Tajikistan and will specialize in the skilledintensive good. By trading with Tajikistan, the relative price of the skilled-intensive good will rise. In western Europe, this leads to an increase in the real earnings of skilled labor and a decrease in the real wage of unskilled labor. The situation would be opposite in the Tajikistan, where the real wage of unskilled labor would increase. 9. Following are data for soybean yield, production, and trade for 2010–2011: Yield Production (metric (100,000 ton/hectare) metric tons) Australia Brazil Canada China France Japan Mexico Russian Federation United States

Export (100,000 metric tons)

Import (100,000 metric tons)

1.71 3.12 2.75 1.89 2.95 1.60 1.32 1.48

0.29 748.2 42.5 144 1.23 2.19 2.05 17.6

0.025 258 27.8 1.64 0.24 0.0006 0.001 0.008

0.007 1.18 2.42 570 5.42 34.6 37.7 10.7

2.79

831

423

4.45

Data from: Food and Agriculture Organization.

Suppose that the countries listed in the table are engaged in free trade and that soybean production is land-intensive. Answer the following: a. In which countries does land benefit from free trade in soybeans? Explain. Answer: Landowners in the United States, Brazil, and Canada benefit from free trade since the production of soybeans intensively uses land as a factor of production, since these countries export more soybeans than they import. b. In which countries does land lose from free trade in soybeans? Explain. Answer: As net importers of soybeans, landowners in China, Mexico, Japan, Russia, and France lose from free trade because the world-relative price of soybeans is lower than each country’s no-trade equilibrium price. c. In which countries does the move to free trade in soybeans have little or no effect on the land rental? Explain. Answer: The move to free trade in soybeans is likely to have little or no effect on the land rental in Australia, since its import and export of the product is about equal. 10. According to the Heckscher–Ohlin model, two countries can equalize wage differences by either engaging in international trade in goods or allowing high-skilled and low-skilled labor to freely move between the two countries. Discuss whether this is true or false, and explain why. Answer: Allowing skilled workers to migrate to skilled-labor-scarce countries and unskilled workers to migrate to unskilled-labor-scarce countries reduces the ratio of skilled/unskilled workers in the skilled-labor-abundant country and raises it in the unskilled-labor-abundant country. This increases the wage ratio between skilled and unskilled labor in the skilled-labor-abundant country and lowers it in the unskilledlabor-abundant country. When the two countries trade in goods that embody these factors, the skilled-laborabundant country will export the skilled-labor-intensive good. By doing so, it effectively sends a lot of skilled workers and a few unskilled workers to the unskilledlabor-abundant country. Likewise, when it imports the unskilled-labor-intensive good, it effectively imports a few skilled workers and a lot of unskilled workers. The net effect is skilled workers in the unskilled-labor-abundant country see a fall in their wage relative to unskilled labor and unskilled workers experience a rise in their relative wage, similar to that of migration. When all the strict assumptions of the Heckscher–Ohlin model are satisfied, we can get this factor price equalization theory: Trade leads to equalization of returns to factors across countries. As product prices in two countries converge to the same world price level, the difference in the factor prices narrows, and ultimately disappears. But this theory should not be viewed as Holy Grail, as it requires “extraordinarily demanding” assumptions that are not quite satisfied in the reality. 11. According to the standard Heckscher–Ohlin model with two factors (capital and labor) and two goods, the movement of Turkish migrants to Germany would decrease

the amount of capital-intensive products produced in Germany. Discuss whether this is true or false, and explain why. Answer: An increase in a factor of production raises the production of the good that uses that factor intensively and reduces the production of the other good. So as labor flows from Turkey to Germany, labor endowment increases in Germany. The production of labor-intensive goods relative to capital-intensive goods will increase in Germany.

5 Movement of Labor and Capital Between Countries 1. Under Headlines: Brussels Resumes Policy Push to Share out Refugees across EU, there is a map showing persons seeking asylum in the European Union, as of May 2015. In this question, you will be asked to update these figures to reflect the most recent data available. The source of the data is Eurostat, available at http://ec.europa.eu/eurostat. Choose “Data” and “Browse statistics by theme.” Under the heading “Population and social conditions,” you will find “Asylum and managed migration.” a. How many asylum seekers are in Germany for the whole of 2015, or in the most recent year available? Also write down the number of asylum seekers in 2015, or the most recent year available, for one other country shown in the Headlines article. Answer: There were 476,620 asylum applicants in Germany in 2015. For Sweden, there were 162,550 asylum applicants in 2015.

b. Use the “Data” tab on the left of this webpage to learn more about the applications of asylum seekers and the decisions on those applications. What is the difference between “first instance” decisions and “final decisions” on asylum applications? Write down the numbers of these decisions for 2015, or the most recent year available, in Germany and in the other country that you chose in part (a). Answer: First instance decision: Decision (positive and negative) considering applications for international protection as well as the grants of authorizations to stay for humanitarian reasons, including decisions under priority and accelerated procedures taken by administrative or judicial bodies in member state. First instance decisions include decisions granted to persons who are subjects of the Dublin Regulation (Council Regulation 604/2013/EC). Final decision: Decision taken by administrative or judicial bodies in appeal or in review and which are no longer subject to remedy. The true “final instance” may be, according to the national legislation and administrative procedures, a decision of the highest national court. However, it is not intended that asylum statistics should cover rare or exceptional cases determined by the highest courts. Thus, the statistics related to the final decisions should refer to what is effectively a final decision in the vast majority of all cases, that is, that all normal routes of appeal have been exhausted. c. What is a “first permit” and how many were issued in Germany and in the other country that you chose, for 2015 or the most recent year available? What is the number of “all valid permits” in these two countries, and how does that compare with the population of these countries? Answer: First permit is the residence permit issued to a person for the first time. In 2014, there were 237,627 first permits issued in Germany and 107,947 in Sweden. In 2014, Germany issued 3,623,807 (4.4% of the German population)

and Sweden issued 388,374 (4.0% of Sweden population) all valid permits. 2. In the short-run specific-factors model, examine the impact on a small country following a natural disaster that decreases its population. Assume that land is specific to agriculture, and capital is specific to manufacturing, whereas labor is free to move between the two sectors. a. In a diagram similar to Figure 5-2, determine the impact of the decrease in the workforce on the output of each industry and the equilibrium wage. Answer: The following diagram depicts a decrease in population (labor) in the specific-factors model. The origin for agriculture shifts inward by exactly the amount of the change in population, carrying with it the curve representing the marginal product of labor in agriculture. (Note: One could equivalently shift the origin and MPL curve in manufacturing and arrive at the same result.) The new equilibrium is determined at the intersection of PM · MPLM and (PA · MPLA )′, which corresponds to a higher wage W′. In manufacturing, the amount of labor decreases from 0ML to 0ML′ and the amount of capital remains the same. As a result, the output of manufacturing decreases. In agriculture, the amount of labor has decreased from 0AL to 0A′L′ (note that (L′ − L) is necessarily less than (0A′ − 0A) and the amount of land remains the same; as a result, the output of agriculture also decreases).

b. What happens to the rentals on capital and land? Answer: Because the quantity of labor in both industries decreases because of the natural disaster, the marginal product of labor increases in both industries (because of diminishing returns) and the marginal products of the industryspecific factors decrease (because of output decrease). Because it is a small country, the final output prices PA and PM remain unchanged; hence, the rental rate for capital, PM · MPK, decreases and the rental rate for land, PA · MPT, decreases.

3. How would your answer to Problem 2 change if instead we use the long-run model, with shoes and computers produced using labor and capital? Answer: In the long-run model, a decrease in labor does not affect factor prices at all. Rather, the output of shoes and computers adjusts: According to the Rybczynski theorem, the output of the labor-intensive industry (shoes) decreases and the output of the capital-intensive industry (computers) increases. This point can be illustrated graphically.

4. Consider an increase in the supply of labor due to immigration, and use the long-run model. Figure 5-7 shows the box diagram and the leftward shift of the origin for the shoe industry. Redraw this diagram but instead shift to the right the origin for computers. That is, expand the labor axis by the amount ∆L but shift it to the right rather than to the left. With the new diagram, show how the amount of labor and capital in shoes and computers is determined, without any change in factor prices. Carefully explain what has happened to the amount of labor and capital used in each industry and to the output of each industry. Answer: Keeping factor prices constant (i.e., W and RK constant), the K/L ratio in each industry remains unchanged. In the diagram below, this means that the slope of the arrows emanating from each origin stays the same even when the total endowments of capital or labor change. Shifting the origin for computers to the right expands the horizontal axis and signifies the increase in labor due to immigration. Finding a new equilibrium involves scaling the arrows up or down from their respective origins to find a unique intersection. In this case, the only possible intersection involves lengthening the shoes arrow and contracting the computers arrow. So, the amount of L and K decreases in the computer industry, but increases in the shoe industry. This illustrates the Rybczynski theorem: The output of the laborintensive industry increases with additional labor in the economy (vice versa for the capital-intensive industry). The new equilibrium is identical to that in Figure 5-8, so it does not matter to which industry the extra labor is initially added.

5. In the short-run specific-factors model, consider a decrease in the stock of land. For example, suppose a natural disaster decreases the quantity of arable land used for planting crops. a. Redraw panel (a) of Figure 5-11 starting from the initial equilibrium at point A. Answer:

b. What is the effect of this change in land on the quantity of labor in each industry and on the equilibrium wage?

Answer: With less land per laborer in the agriculture sector, MPLA decreases. This is represented by an inward shift in the wage curve for agriculture and leads to a new equilibrium at point B. In words, wages in the agriculture sector drop, drawing labor into the manufacturing sector. The increased labor supply in the manufacturing sector puts downward pressure on the wage. In the new equilibrium, wages are once again equalized across industries at W′ < W, manufacturing labor increases from 0ML to 0ML′, and agriculture labor decreases from 0AL to 0AL′. c. What is the effect on the rental on land and the rental on capital? Answer: In the manufacturing industry, the quantity of labor increases and the amount of capital remains the same (i.e., the labor/capital ratio increases). Therefore, the marginal product of capital increases because of the natural disaster because each unit of capital has more laborers working with it. As a result, the rental on capital, PM · MPK, increases. In agriculture, the result seems ambiguous at first. On one hand, the natural disaster decreases the stock of land, which increases the marginal product of land. On the other hand, the movement of labor from agriculture to manufacturing decreases the marginal product of land. Which one of these effects is stronger? It is possible to answer this question by looking at the move from A to B in steps. Consider the contraction in the marginal product of labor in agriculture from A to C: The wage is held constant by (L′′ − L) workers leaving the agriculture industry. Because the wage has not changed, neither has the labor/land ratio or the rental on land. Then, allowing workers to migrate back into agriculture and holding the amount of land fixed, going from C to B, the wage is depressed to W′ and the marginal product of land increases. Combining these steps, the land rental, PA · MPT, increases from A to B.

d. Now suppose that the international community wants to help the country struck by the natural disaster and decides to do so by increasing its level of FDI. So the

rest of the world increases its investment in physical capital in the stricken country. Illustrate the effect of this policy on the equilibrium wage and rentals. Answer: An increase in FDI increases the amount of capital in manufacturing, shifting out the wage curve in that sector. This has the effect of raising MPLM and hence wages, drawing additional labor into that sector. The new equilibrium occurs at a higher wage than after the disaster. (The total effect as compared with before the disaster will depend on the relative magnitude of the loss in land and inflow of capital, and is therefore ambiguous.) The agriculture sector shrinks further due to the capital inflow, but those still employed in it enjoy a higher wage than after the disaster. (We do not know if the wage is higher or lower than before the disaster.)

As shown in the graph, suppose the wage curve of manufacturing shifts to the right and the new equilibrium point moves from B to D, then equilibrium wage rises from W′ to W′′. Labor used in agriculture further decreases and labor used in manufacturing further increases compared with point B. With output, agriculture drops, land remains unchanged, and land rental decreases with MPTA. How capital rental changes seems ambiguous at first. But point B and point E have the same MPK and therefore the same RK. Points D and E use the same amount of capital, but the wage at point D is higher, so earnings on capital must decrease. Hence, compared with the disaster (point B), capital rental decreases at point D as a result of FDI inflow. 6. According to part A of Table 5-1, what education level loses most (i.e., has the greatest decrease in wage) from immigration to the United States? Does this result depend on keeping the rental on capital constant? Explain why or why not. Answer: In the short run, holding capital fixed, the table shows immigration has the greatest negative impact on workers with very low or high levels of education and only a small negative impact on those workers with mid-level education (12–15

years). This finding is consistent with the specific factors model. In the long-run, when capital adjusts to keep the real return to capital fixed in each industry, the impacts are even smaller: In that case, workers with very low or high levels of education lose because of immigration, but workers with mid-level education gain due to the immigration combined with the capital adjustment. The reason that the losses are smaller (and even become gains) in the long run is that immigration leads to capital growth in industries. Furthermore, the fraction of immigrants in the U.S. workforce is largest for those with the lowest and highest education levels. So the workers in these two groups face the greatest competition and their wages suffer the greatest loss. Work It Out Suppose that computers use 4 units of capital for each worker, so that KC = 4 · LC, whereas shoes use 0.2 units of capital for each worker, so that KS = 0.2 · LS. There are 200 workers and 200 units of capital in the economy. a. Solve for the amount of labor and capital used in each industry. Hint: The box diagram shown in Figure 5-6 means that the amount of labor and capital used in each industry must add up to the total for the economy, so that KC + KS = 200

and

LC + LS = 200

Use the facts that KC = 4 · LC and KS = 0.2 · LS to rewrite these equations as: 4 · LC + 0.2 · LS = 100 and

LC + LS = 200

Use these two equations to solve for LC and LS, and then calculate the amount of capital used in each industry using KC = 4 · LC and KS = 0.2 · LS. Answer: The above two equations can be solved as: 4LC + 0.2LS = 200 4LC + 4LS = 800 −3.8LS = −600 so that LS = 600/3.8 = 157.9. It follows from the same equations that LC = 42.1, and that KC = 4LC and KS = 0.2LS. b. Suppose that the number of workers increases to 250 because of immigration, keeping total capital fixed at 200. Again, solve for the amount of labor and capital used in each industry. Hint: Redo the calculations from part (a), but using LC + LS = 250. Answer: The labor equations are now solved as: 4LC + 0.2LS = 200 4LC + 4LS = 1,000

−3.8LS = −800 so that LS = 800/3.8 = 210.5. It follows from the same equations that LC = 39.50, and that KC = 4LC = 158 and KS = 0.2LS = 42. c. Suppose instead that the amount of capital increases to 250 due FDI, keeping the total number of workers fixed at 200. Again solve for the amount of labor and capital used in each industry. Hint: Redo the calculations from part (a), using KC + KS = 250. Answer: The first labor equation is now: 4LC + 0.2LS = 250, so the labor equations are solved as: 4 LC + 0.2 LS = 200 4LC + 4 LS = 800 −3.8LS = −550 so that LS = 550/3.8 = 144.7. It follows from the same equations that LC = 55.3, and that KC = 4LC = 221.2 and KS = 0.2LS = 28.8. d. Explain how your results in parts (b) and (c) are related to the Rybczynski theorem.

Computer Shoe

K L K L

(a) Original 168.4 42.1 31.6 157.9

(b) Immigration 158 39.5 42 210.5

Answer: Comparing part (a) with part (b), the amount of labor in the economy has increased the amount of labor and capital devoted to shoes (from LS = 157.9 and KS = 331.6 to LS = 210.5 and KS = 42) and decreased the amount of labor and capital devoted to computers (from LC = 42.1 and KC 168.4 to LC = 39.5 and KC = 158). Therefore, the output of shoes increases and the output of computers decreases, due to the overall increase in labor. Shoes are labor-intensive because they use 0.2 units of capital per unit of labor; computers are capital-intensive because they use 4 units of capital per unit of labor. So the change in outputs is in accordance with the Rybczynski theorem; the increase in labor has increased the output of the labor-intensive good and decreased the output of the other good. Conversely, comparing part (b) with part (c), there has been an increase in the amount of capital in the economy. Consistent with the Rybczynski theorem, there has been a rise in the amount of labor and capital devoted to computer production (from LC = 39.5 and KC = 158 to LC = 55.3 and KC = 221.2) and a fall in the amount of labor and capital devoted to shoe production (from LS = 210.5 and KS = 42 to LS = 144.7 and KS = 28.8).

Questions 7 and 8 explore the implications of the Rybczynski theorem and the factor price insensitivity result for the Heckscher–Ohlin model from Chapter 4. 7. In this question, we use the Rybczynski theorem to review the derivation of the Heckscher–Ohlin theorem. a. Start at the no-trade equilibrium point A on the Home PPF in Figure 4-2, panel (a). Suppose that through immigration, the amount of labor in Home grows. Draw the new PPF, and label the point B where production would occur with the same prices for goods. Hint: You can refer back to Figure 5-8 to see the effect of immigration on the PPF. Answer: Figure 5-8, reproduced below, shows the shift in the Home PPF due to the inflow of labor. With the same prices for goods, production occurs at point B, with greater output of shoes and less output of computers, in accordance with the Rybczynski theorem.

b. Suppose that the only difference between Foreign and Home is that Foreign has more labor. Otherwise, the technologies used to produce each good are the same across countries. Then how does the Foreign PPF compare with the new Home PPF (including immigration) that you drew in part (a)? Is point B the no-trade equilibrium in Foreign? Explain why or why not. Answer: The Foreign PPF is shifted out and upward as compared with the original Home PPF, just like immigration shifted out the Home PPF. This result follows because the only difference between Home and Foreign is that Foreign has more labor (but has the same technologies for producing the two goods as at

Home). Therefore, the Foreign PPF is shifted out as compared with the original Home PPF, and is, in fact, identical to the Home PPF inclusive of the immigration inflow. Assuming that point A is the no-trade equilibrium at Home, and that the two countries have the same tastes, then point B cannot be the no-trade equilibrium in Foreign. The reason for this is that because an indifference curve is tangent to the Home no-trade equilibrium at point A, an indifference cannot also be tangent to point B. The slope of the indifference curve at point B equals that at point A, meaning the relative price of computers to shoes is the same. However, since Foreign is labor-abundant compared with Home, the no-trade equilibrium relative price of computers has to be higher than at Home (or the tangency point must be to the right of point B). c. Illustrate a new point, A*, that is the no-trade equilibrium in Foreign. How do the relative no-trade prices of computers compare in Home and Foreign? Therefore, what will be the pattern of trade between the countries, and why? Answer: The Foreign no-trade point A* is shown with an indifference curve tangent to it. The slope of the Foreign indifference curve at A* exceeds the slope of the Home indifference curve at A. Because the slopes of the indifference curves are the relative price of computers (the good on the horizontal axis), this proves that the no-trade relative price of computers in Foreign exceeds the notrade relative price of computers at Home. With trade, Home will export computers (to obtain the higher relative price in Foreign), and Foreign will export shoes (to obtain the higher relative price at Home). Because Foreign is laborabundant, this trade pattern is in accordance with the Heckscher–Ohlin theorem. Note: This question has redone the proof of the Heckscher–Ohlin theorem from the beginning of Chapter 4. Because we now have used the Rybczynski theorem in part (a), the comparison of the Home and Foreign PPFs is more precise than we achieved at the beginning of Chapter 4 (where we relied on an intuitive comparison of the two countries’ PPFs). 8. Continuing from Problem 7, we now use the factor price insensitivity result to compare factor prices across countries in the Heckscher–Ohlin model. a. Illustrate the international trade equilibrium on the Home and Foreign production possibility frontiers. Hint: You can refer back to Figure 4-3 to see the international trade equilibrium. Answer: The international trade equilibrium is as shown in Figures 4-3 and 4-4, with Home exporting computers and Foreign exporting shoes. Both countries face the same world relative price of computers (or shoes). b. Suppose that the only difference between Foreign and Home is that Foreign has more labor. Otherwise, the technologies used to produce each good are the same across countries. Then, according to the factor price insensitivity result, how will the wage and rental compare in the two countries? Answer: This is just like Problem 7, where Foreign has more labor than Home but is otherwise identical. In particular, once open to trade, they face the same

world relative price. Given the same technology, the factor prices will be equal in both countries (because W = P · MPL and RK = P · MPK). So according to the factor price insensitivity result, the inflow of labor (into Foreign) has no effect on the wage or rental (as compared with those earned at Home). In other words, the wage and rental in the two countries are the same! This result is called the factor price equalization theorem and applies to countries trading in the Heckscher– Ohlin model, where technologies are the same across countries. c. Call the result in part (b) “factor price equalization.” Is this a realistic result? Hint: You can refer to Figure 4-9 to see wages across countries. Answer: The factor price equalization theorem is a logical result in the Heckscher–Ohlin model, but it is not a very realistic result, because of the strict assumptions in this model. In Figure 4-11 we showed that wage differs a great deal across countries, whereas the factor price equalization theorem would predict that wages are the same. d. Based on our extension of the Heckscher–Ohlin model at the end of Chapter 4, what is one reason why the factor price equalization result does not hold in reality? Answer: The reason that the factor price equalization theorem does not hold in practice is that technologies differ quite a bit across countries, as we discussed at the end of Chapter 4. Just like we need to take into account the differences in technologies to obtain more realistic predictions about trade from the Heckscher– Ohlin model, so too we need to recognize that the differences in technologies will mean that factor prices differ across countries, even when they are engaged in free trade and the relative prices of goods are the same. Please refer to Chapter 4, Problem 11 for more discussion. 9. Recall the formula from the application, “The Effect of FDI on Rentals and Wages in Singapore.” Give an intuitive explanation for this formula for the rental rate. Hint: Describe one side of the equation as a marginal benefit and the other as a marginal cost. Answer: The equation presented is one way to calculate the real returns to (rental of) capital R/P. An intuitive way to think about this is to imagine that you are the owner of a unit of capital and you are considering whether to rent it out at the prevailing nominal rental rate R or to sell it and invest the proceeds. On one hand, you could sell each unit of capital for a price of PK and receive interest income on the proceeds of PKi. On the other hand, you could rent out the capital for a nominal payment of R and incur the direct depreciation cost of the asset of PKd. Thus, the nominal payment you would require (R, the marginal benefit of rental) to make you indifferent between the two options would be PKi + PKd, the sum of direct costs of renting out and the opportunity cost of a sale (together, the marginal cost of rental). Dividing both sides by the price level P puts the equation into real terms and yields the desired equation. 10. In Table 5-2, we show the growth in the real rental and real wages in Singapore, along with the implied productivity growth. One way to calculate the productivity

growth is to take the average of the growth in the real rental and real wage. The idea is that firms can afford to pay more to labor and capital if there is productivity growth, so in that case real factor prices should be growing. But if there is no productivity growth, the average of the growth in the real rental and real wage should be close to zero. To calculate the average of the growth in the real factor prices, we use the shares of GDP going to capital and labor. Specifically, we multiply the growth in the real rental by the capital share of GDP and add the growth in the real wage multiplied by the labor share of GDP. Then answer the following: a. For a capital-rich country like Singapore, the share of capital in GDP is about one-half and the share of labor is also one-half. Using these shares, calculate the average of the growth in the real rental and real wage shown in each row of Table 5-2. How do your answers compare with the productivity growth shown in the last column of Table 5-2? Answer: As shown in column (3) of the table, when using a capital share of 0.5, as applies for a country like Singapore, the implied productivity growth is close to that in Table 5-2, shown in column (5). (1) Rental

(2) Wages

−5.0 −1.9 −3.4 1.6 −0.2 −0.5

2.6 0.5 1.6 2.7 3.2 3.6

(3) Productivity Using Capital Share of 0.5 = (1) · 0.5 + (2) · 0.5 −1.2 −0.7 −0.9 2.2 1.5 1.6

(4) Productivity Using Capital Share of 0.33 = (1) · 0.33 + (2) · 0.67 0.1 −0.3 −0.1 2.3 2.1 2.2

(5) Productivity from Table 5-2 −1.5 −0.7 −1.1 2.2 1.5 1.6

b. For an industrialized country like the United States, the share of capital in GDP is about one-third, and the share of labor in GDP is about two-thirds. Using these shares, calculate the average of the growth in the real rental and real wage shown in each row of Table 5-2. How do your answers now compare with the productivity growth shown in the last column? Answer: As shown in column (4) of the table, when using a capital share of 0.33, as applies for a country like the United States, the implied productivity growth is not as close to that in Table 5-2, shown in column (5). 11. Figure 5-14 is a supply and demand diagram for the world labor market. Starting at points A and A*, consider a situation where some Foreign workers migrate to Home but not enough to reach the equilibrium with full migration (point B). As a result of the migration, the Home wage decreases from W to W′′ > W′, and the Foreign wage increases from W* to W** < W′.

a. Are there gains that accrue to the Home country? If so, redraw the graph and identify the magnitude of the gains for each country. If not, say why not. Answer: Gains from trade in the following graph are analogous to consumer and producer surplus in the conventional supply and demand setting. In this case, Home employers are willing to pay up to W for the marginal product of labor that they obtain for W′′; thus the gains to the Home country are illustrated by the horizontally striped triangle. Similarly, the immigrating Foreign workers are willing to supply their marginal product for a lower wage in the Foreign country (W*) but receive a higher wage in the Home country (W**).

b. Are there gains that accrue to the Foreign country? If so, again show the magnitude of these gains in the diagram and show the world gains. Answer: Gains to Foreign (including foreign emigrants) are represented by the vertically striped triangle. Given positive gains to both countries, total gains from immigration are also positive in this model. 12. A housekeeper from the Philippines is contemplating immigrating to Singapore in search of higher wages. Suppose that the housekeeper earns approximately $3,000 annually and expects to find a job in Singapore worth approximately $8,000 annually for a period of 3 years. Furthermore, assume that the cost of living in Singapore is $800 more per year than at home. a. What can we say about the productivity of housekeepers in Singapore versus the Philippines? Explain. Answer: Assuming that housekeeping is a perfectly competitive industry, housekeepers’ wages are equal to their marginal product of labor. Because wages are higher in Singapore, housekeepers there are more productive.

b. What is the total gain to the housekeeper from migrating? Answer: The total gains from migrating are the net benefits relative to staying in the Philippines—that is, salary of $8,000 minus the opportunity cost of working in the Philippines of $3,000, minus the extra costs of living in Singapore of $800. Annual gains from migrating (over the first 3 years) are $4,200. c. Is there a corresponding gain for the employer in Singapore? Explain. Answer: The gains to the employer in Singapore depend on whether the wage of housekeepers is driven down by the migration, as shown in Problem 11.

6 Increasing Returns to Scale and Monopolistic Competition 1.

a. Of two products, rice and paintings, which product do you expect to have a higher index of intra-industry trade? Why? Answer: We would expect that paintings would have a higher index of industry trade, because they are differentiated goods, unlike rice. b. Access the U.S. TradeStates Express website at http://tse.export.gov/tse/tsehome.aspx. Click on “National Trade Data” and then “Global Patterns of U.S. Merchandise Trade.” Under the “Product” section, change the item to rise (HS 1006) and obtain the export and import values. Do the same for paintings (HS 9701); then calculate the intra-industry trade index for rice and paintings in 2012. Do your calculations confirm your expectation from part (a)? If your answers did not confirm your expectation, explain. Answer: Index of intra-industry trade = Minimum of imports and exports 1

(HS 1006) – RICE Exports = 2,058,452,216

(Imports + exports)

Imports = 659,344,169 Index of ITTRICE =

659,344,169

(659,344,169 + 2,058,452,216)

= 99.8%

2. Explain how increasing returns to scale in production can be a basis for trade. Answer: With increasing returns to scale, countries benefit from trade because of the potential to reduce their average costs by expanding their outputs through selling in a larger market. 3. Why is trade within a country greater than trade between countries? Answer: Border effects prevent trade between countries from being as large as within countries. These factors include tariffs, quotas, administrative rules and regulations, and whether the countries have a common border, culture, or language. 4. Starting from the long-run equilibrium without trade in the monopolistic competition model, as illustrated in Figure 6-5, consider what happens when the Home country begins trading with two other identical countries. Because the countries are all the same, the number of consumers in the world is three times larger than in a single country, and the number of firms in the world is three times larger than in a single country.

a. Compared with the no-trade equilibrium, how much does industry demand D increase? How much does the number of firms (or product varieties) increase? Does the demand curve D/NA still apply after the opening of trade? Explain why or why not. Answer: Industry demand increases by three times, and the number of firms also increases by three times. Compared with the no-trade equilibrium, the demand curve D/NA does not change because both total quantity demanded and the number of firms tripled. b. Does the d1 curve shift or pivot due to the opening of trade? Explain why or why not. Answer: Because D/NA is unchanged, point A is still on the short-run demand curve facing each firm (d2 in Figure 6-6). However, the demand curve faced by each firm becomes more elastic due to the increase in the number of firms: d1 pivots to become flatter, like d2 in Figure 6-6. c. Compare your answer to (b) with the case in which Home trades with only one other identical country. Specifically, compare the elasticity of the demand curve d1 in the two cases. Answer: In the case with three countries, Home consumers have more varieties to choose from compared with the two-country case. For that reason, the demand curve facing each firm d1 is flatter (more elastic) when there are more trading partners. d. Illustrate the long-run equilibrium with trade, and compare it with the long-run equilibrium when Home trades with only one other identical country. Answer: The long-run equilibrium with trade occurs where the demand curve facing the firm is tangent to the average cost curve, to the right of the long-run equilibrium without trade (due to the exit of firms from the industry). Because the demand curve facing each firm with trade (d3) is flatter when there are three countries compared with two, it will end up further down the average cost curve in Figure 6-7. Therefore, firms will produce a greater quantity, at lower average cost, than the in the two-country case. 5. Starting from the long-run trade equilibrium in the monopolistic competition model, as illustrated in Figure 6-7, consider what happens when industry demand D increases. For instance, suppose that this is the market for cars, and lower gasoline prices generate higher demand D. a. Redraw Figure 6-7 for the Home market and show the shift in the D/NT curve and the new short-run equilibrium. Answer: The increase in demand shifts the D/NT curve to the right, dragging along the curves d3 and mr3. Each firm produces Q4 at a price of P4 attempting to earn monopoly profits at point D, and when all firms do so they move along the new D/NT curve to point E.

b. From the new short-run equilibrium, is there exit or entry of firms, and why? Answer: In the short-run with trade, monopoly profits are positive because price exceeds average cost. As a result, firms enter the industry and NT increases. c. Describe where the new long-run equilibrium occurs, and explain what has happened to the number of firms and the prices they charge. Answer: In the long-run with trade, firm entry shifts D/NT and d4 to the left and makes d4 more elastic until it is tangent to the average cost curve. At that point, monopoly profits are zero and firms no longer enter the industry. Relative to the short-run equilibrium in (b), the number of firms increases and price decreases. 6. Our derivation of the gravity equation from the monopolistic competition model used the following logic: (i) Each country produces many products. (ii) Each country demands all of the products that every other country produces. (iii)Thus, large countries demand more imports from other countries. The gravity equation relationship does not hold in the Heckscher–Ohlin model. Explain how the logic of the gravity equation breaks down in the Heckscher–Ohlin model; that is, which of the statements just listed is no longer true in the Heckscher– Ohlin model? Answer: The Heckscher–Ohlin model assumes perfect competition. Therefore, each country produces many products. However, in the Heckscher–Ohlin model not all products produced in other countries (in autarky) are imported under trade. Products are not differentiated and we observe only inter-industry trade. Countries specialize in the good that uses their abundant factor intensively. Hence larger countries do not necessarily demand more imports from other countries. Countries differ by

endowment, not by size. Trade between two countries is also balanced trade. Work It Out The United States, Japan, and China are among the world’s largest producers. To answer the following questions, assume that their markets are monopolistically competitive, and use the gravity equation with B = 93 and n = 1.25.

China Japan United States

GDP in 2012 ($ billions) 11,385 4,116 17,968

Distance from the United States (miles) 7,245 6,314 —

a. Using the gravity equation, compare the expected level of trade between the United States and Japan and between the United States and China. Answer: The expected level of trade between the United States and China is 93(11,385 · 17,968)/7,2451.25 = $284,621.52 billion. The expected level of trade between the United States and Japan is 93(4,116 · 17,968)/6,3141.25 = $122,201.72 billion. (Note: These numbers are larger than is realistic because we are using the gravity equation estimated on the United States and Canada state/provincial trade, rather than the equation estimated on international trade.) b. The distance between Beijing and Tokyo is 1,302 miles. Would you expect more trade between China and Japan or between China and the United States? Explain what variable (i.e., country size or distance) drives your result. Answer: The expected level of trade between China and Japan is 93(11,385 · 4,116)/1,3021.25 = $557,221.18 billion. This number is so large because it reflects the short distance between the two countries. Even though Japan’s GDP is much smaller than that of the United States, the short distance between China and Japan dominates the size effect here. In particular, this number is larger than the predicted amount of trade between the United States and Japan, as calculated in part (a). 7. What evidence is there that Canada is better off under the free-trade agreement with the United States? Answer: Economist Daniel Trefler found that between 1988 and 1996 the productivity of Canadian firms increased by as much as 18% in industries most affected by the tariff cuts. Despite the short-run adjustment cost of job loss, new jobs were created elsewhere in manufacturing over the long run. The growth in productivity translates to an increase in real earnings of 3% over the 8-year period. Moreover, Canadian consumers gained from the fall in prices and the rise in product variety. 8. In the section “Gains and Adjustment Costs for the United States under NAFTA,” we

calculated the lost wages of workers displaced due to NAFTA. Prior experience in the manufacturing sector shows that about two-thirds of these workers obtain new jobs within three years. One way to think about that reemployment process is that onethird of workers find jobs in the first year, and another one-third of remaining unemployed workers find a job each subsequent year. Using this approach, in the table that follows, we show that one-third of workers get a job in the first year (column 2), leaving two-thirds of workers unemployed (column 4). In the second 1 2 2 1 2 5 year, another ( ) · ( ) = of workers get a job (column 2), so that ( ) + ( ) = of the 3

workers are employed (column 3). That leaves 1 – = of the workers unemployed 9 9 (column 4) at the end of the second year.

Year

Fraction Finding Job 1 3 1 2 2 · =

1 2 3

3 1

3 4

· =

· ( )Year−1

4 5 6

Total Fraction Employed 1 3 1 2 5 + =

9 4

Total Fraction Unemployed 1 2 1– = 3 5

1– =

3 4 9

a. Fill in two more rows of the table using the same approach as for the first two rows. Answer: Year 1 2 3 4 5 6

Fraction Finding Job 1 3 1 2 2 · =

Total Fraction Employed 1 3 1 2 5 + =

3 1

9 27 19 8

3 1

· =

1 3

3 4

9 8

9 4

27 8

· ( )Year−1

3 5

9 4

Total Fraction Unemployed 1 2 1– = 3

1–

27 65

1– = 1–

3 4

9 9 19 8

27 65 81

= =

27 16 81

b. Notice that the fraction of workers finding a job each year (column 2) has the formula 1

Fraction finding job = · ( )Year−1 3

Using this formula, fill in six more values for the fraction of workers finding a job (column 2), up to year 10. Answer: Year 1 2

Fraction Finding Job 1 3 1 2 2 · =

Total Fraction Employed 1 3 1 2 5 + =

3 1

3 4

· = 0.15 9 8

· = 0.10 27 0.07 0.04 0.03 0.02 0.01 0.01 3

5 6 7 8 9 10

3 5

+ 0.15 = 0.7 0.80 0.87 0.91 0.94 0.96 0.97 0.98

Total Fraction Unemployed 1 2 1– = 3 5

3 4

1– = 9 9 1 – 0.7 = 0.30 0.20 0.13 0.09 0.06 0.04 0.03 0.02

c. To calculate the average spell of unemployment, we take the fraction of workers finding jobs (column 2), multiply it by the years of unemployment (column 1), and add up the result over all the rows. By adding up over 10 rows, calculate what the average spell of unemployment is. What do you expect to get when adding up over 20 rows? Answer: We get 2.79 over 10 years, and would expect ≈3 over 20 years. Year 1 2 3 4 5 6 7 8 9 10

Fraction Total Finding Job Fraction Employed 0.33 0.33 0.22 0.56 0.15 0.70 0.10 0.80 0.07 0.87 0.04 0.91 0.03 0.94 0.02 0.96 0.01 0.97 0.01 0.98

Total Fraction Unemployed 0.67 0.44 0.30 0.20 0.13 0.09 0.06 0.04 0.03 0.02

Average Spell 0.33 0.44 0.45 0.40 0.35 0.24 0.21 0.16 0.09 0.10 Sum = 2.79

d. Compare your answer to (c) with the average three-year spell of unemployment on page 191. Was that number accurate?

Answer: We had assumed that the average spell of unemployment was 3 years, which is accurate!

7 Offshoring of Goods and Services 1. What type of occupation would you like to pursue after graduation? To see what is available, to the Bureau of Labor Statistics website at: https://www.bls.gov/ooh/. a. Find four occupations that you think fit the four categories shown in the horizontal axis of Figure 7-11: nonroutine manual jobs; routine manual jobs; routine cognitive jobs; and nonroutine cognitive jobs. For each occupation, what is the growth in employment in the United States, and how does it compare with the employment growth since 1990 shown in Figure 7-11? Answer: Nonroutine manual jobs: Home health aides with growth rate (38%) Routine manual jobs: Assemblers and fabricators with growth rate (–1%) Routine cognitive jobs: Secretaries and administrative assistants with growth rate (3%) Nonroutine cognitive jobs: Mathematicians with growth rate (21%) There is a polarization pattern compared to the situation decades ago. The nonroutine cognitive and nonroutine manual jobs grow much faster than before, whereas the middle jobs grow slowly. b. Choose an occupation that you would most like to pursue, and explain why you wish to pursue it. What is the employment growth for that occupation? Answer: This is an open question; one can answer it from various dimensions, for example, the expected return of the chosen occupation. Work It Out Consider an offshoring model in which the the hours of labor used in four activities in the United States and Mexico are as in the table follows. Note that labor hours in Mexico are twice those in the United States, reflecting Mexico’s lower productivity. Also note that the ratio of high-skilled to low-skilled labor used in each activity increases as we move to the right, from 1/6 in assembly to 10/1 in R&D. Suppose that the wage of U.S. low-skilled workers is $10 per hour and that of highskilled workers is $25 per hour, and that the wage of Mexican low-skilled workers is $1 per hour and that of high-skilled workers is $5 per hour (these values are made up to be convenient, not realistic). Also suppose that the trade costs are 25%, 30%, or 50%, which means that an additional 25%, 30%, or 50% is added to the costs of offshoring to Mexico. Hours of Labor Used in Each Activity (per unit of output): Assembly Low-skilled labor

Mexico: 24

Component Production Mexico: 16

Office Services Mexico: 16

R&D Mexico: 4

High-skilled labor High-skilled/lowskilled ratio

U.S.: 6 Mexico: 4 U.S.: 1 1/6

U.S.: 4 Mexico: 4 U.S.: 1 1/4

U.S.: 4 Mexico: 8 U.S.: 2 1/2

U.S.: 1 Mexico: 40 U.S.: 10 10/1

Fill in the blank cells in the following table by computing the costs of production of each activity in each country (two cells are filled in for you).

Mexico United States Imported by United States from Mexico, Trade Costs = 25% Imported by United States from Mexico, Trade Costs = 30% Imported by United States from Mexico, Trade Costs = 50%

Assembly Component Office Production Services $44

R&D

$57.2

Answer: In italics in the following table:

Mexico United States Imported by U.S. from Mexico, Trade costs = 25% Imported by U.S. from Mexico, Trade costs = 30% Imported by U.S. from Mexico, Trade costs = 50%

Assembly Component Production $44 $36 $85 $65 $55 $45

Office Services $56 $90 $70

R&D

$57.2

$46.8

$72.8

$265.2

$66

$54

$84

$306

$204 $260 $255

R&D, research and development; U.S., United States. b. With trade costs of 50%, where is the value chain sliced? That is, which activities are cheaper to import from Mexico and which are cheaper to produce in the United States? Answer: With trade costs of 50%, assembly and component production are done in Mexico because the gross costs of importing these activities are lower than their respective costs in the United States. On the other hand, office services and R&D activities are done in the United States. c. With trade costs of 30%, and then 25%, where is the value chain sliced?

Answer: With trade costs of 25%, all activities are offshored to Mexico, whereas with trade costs of 30%, assembly, component production, and office services are done in Mexico (R&D is still done in the United States). 2. Consider an offshoring model in which Home’s skilled labor has a higher relative wage than Foreign’s skilled labor and in which the costs of capital and trade are uniform across production activities. a. Will Home’s offshored production activities be high or low on the value chain for a given product? That is, will Home offshore production activities that are highskilled-intensive, or low-skilled-intensive? Explain. Answer: The high relative wage of Home high-skilled labor makes high-skilledlabor-intensive activities more expensive at Home relative to Foreign. Equivalently, the low relative wage of low-skilled labor makes low-skilled-laborintensive activities less expensive at Home relative to Foreign. As a result, Home will undertake production activities lower on the value chain while offshoring higher value activities to Foreign. For example, Boeing outsourced part of its R&D to Germany. b. Suppose that Home uniformly increases its tariff level, effectively increasing the cost of importing all goods and services from abroad. How does this affect the slicing of the value chain? Answer: A uniform increase in the tariff level causes fewer activities to be offshored. The slicing of the value chain reflects this increased cost as a rightward shift; Home expands the set of activities that it does at Home to include incrementally high-value activities, whereas the set of high-value offshored activities shrinks. c. Draw relative labor supply and demand diagrams for Home and Foreign showing the effect of this change. What happens to the relative wage in each country? Answer: An expansion in the set of production activities done at Home (to include higher-value ones) increases the average skill intensity of Home production. This increases the relative demand for high-skilled labor at Home. Similarly, because Foreign ceases to do its least skill-intensive activities, the average skill intensity in Foreign increases and hence the relative demand for high-skilled labor increases. See the following figure.

3. Consider a U.S. firm’s production of automobiles, including research and development and component production. a. Starting from a no-trade equilibrium in a PPF diagram, illustrate the gains from offshoring if the United States has comparative advantage in component production. Answer: See the following figure, where the offshoring equilibrium is B and C. Since the United States has comparative advantage in component production, the world relative price of components is higher and correspondingly steeper in the figure. Production will shift to point B, and by exporting components and importing R&D along the world price line, the U.S. firm ends up at point C. Production of the final good at point C is Y1, which exceeds the production Y0 in the no-trade equilibrium. Thus the U.S. firm enjoys greater gains from offshoring when the output of automobiles increases from Y0 to Y1.

b. Now suppose that advances in engineering abroad decrease the relative price of

research and development. Illustrate this change on your diagram and state the implications for production in the United States. Answer: See the following figure, where the new equilibrium is B′ and C′. A lower R&D price will shift the world price line further down along the PPF curve and the new tangency is B′. Given this higher world relative price of components, the United States is able to produce even more automobiles at Y2 level.

c. Does the U.S. firm gain from advances in research and development abroad? Explain why or why not. Answer: Because the United States imports R&D and exports components, a decrease in the relative price of R&D abroad represents an improvement in the U.S. terms of trade; as a result, U.S. output increases to Y2 so there are gains for the United States. 4. Consider the model of a firm that produces final goods using R&D and components as inputs, with cost data as follows: Components:

R&D:

Total costs of production = PC · QC = 200 Earnings of high-skilled labor = WH · HC = 20 Earnings of low-skilled labor = WL · LC = 80 Earnings of capital = R · KC = 100 Share of total costs paid to high-skilled labor = 20/200 = 10% Share of total costs paid to low-skilled labor = 80/200 = 40% Total costs of R&D = PR · QR = 200 Earnings of high-skilled labor = WH · HR = 80 Earnings of low-skilled labor = WL · LR = 20 Earnings of capital = R · KR = 100

Share of total costs paid to high-skilled labor = 80/200 = 40% Share of total costs paid to low-skilled labor = 20/200 = 10% a. In which factor(s) is components intensive? In which factor(s) is R&D intensive? Answer: Component production is intensive in the use of low-skilled labor, because the cost share of low-skilled labor in components (40%) exceeds the cost share of low-skilled labor in R&D (10%). Similarly, R&D is intensive in the use of high-skilled labor, because the cost share of high-skilled labor in R&D (40%) exceeds the cost share of high-skilled labor in components (10%). Notice that capital is used equally in both activities, so it is not intensive in either one. b. Suppose that due to the opening of trade, the price of components falls by ∆ PC/PC = –10%, and the price of R&D remains unchanged, ∆PR/PR = 0. Using the hint below, calculate the change in the wage of skilled and low-skilled labor. Hint: We follow a procedure similar to that used in Chapter 4 when calculating the change in factor prices in the Heckscher–Ohlin model. First, write the total costs in each activity as consisting of the payments to labor and capital: PC · QC = R · KC + WH · HC + WL · LC, for components PR · QR = R · KR + WH · HR + WL · LR, for R&D Because we assume that 50% of costs in components or R&D are always paid to capital, then R · KC = 0.5(PC · QC) and R · KR = 0.5(PR · QR), so we can rewrite the above two equations as 0.5(PC · QC) = WH · HC + WL · LC, for components 0.5(PR · QR) = WH · HR + WL · LR, for R&D Taking the change in these equations: 0.5(∆PC · QC) = ∆WH · HC + ∆WL · LC, for components 0.5(∆PR · QR) = ∆WH · HR + ∆WL · LR, for R&D Dividing the equations by (∆PC · QC) and (∆PR · QR), respectively, we can rewrite the equations as  ∆P  = 0.5  C   PC   ∆P  = 0.5  R   PR 

 ∆WH   WH ·HC   ∆WL   WL ·HC  +  , for components     WH   PC ·QC   WL   PC ·QC   ∆WH  WH ·H R   ∆WL  WL ·H R    +   , for R&D  WH  PR ·QR   WL  PR ·QR 

Use the cost shares and price change data in these formulas to get

 ∆WH   20   ∆WL   80  = −5%    +  , for components  WH   200   WL   200   ∆WH   80   ∆WL   20  = 0    +  , for R&D  WH   200   WL   200 

Now solve these two equations for the change in the high-skilled wage, (∆WH/WH ), and the change in the low-skilled wage, (∆WL/WL). Answer: There are many ways to solve the last two equations for the change in the wages (∆WH/WH), and (∆WL/WL). One method is to eliminate the term for the percentage change of the high-skilled wage; this can be done by multiplying the first equation by 4 and subtracting the second equation from it, to get:  ∆WL   300  −20% =     WL   200 

It follows that (∆WL/WL) = –13.3% so that the wage for low-skilled labor falls by 13.3% when the price of components falls by 10%. To find the change in the highskilled wage, we can take this solution, and plug it back into the equation for the change in wages in R&D, to get: (ΔWH/WH) = 13.3% · (10/40) = 3.3%. The wage for high-skilled labor increases by 3.3% when the price of components falls by 10%. c. What has happened to the relative wage of high-skilled/low-skilled labor? Does this match the predictions of the offshoring model in this chapter? Answer: With the wage for high-skilled labor going up, and the wage for lowskilled labor going down, it follows that the relative wage of high-skilled labor (WH/WL) also rises. Equivalently, the relative wage of low-skilled labor, which is (WL/WH), falls. This is as predicted by our model in this chapter, where a fall in the relative price of components or a rise in the relative price of R&D benefits high-skilled labor. 5. Consider the model of a firm that produces final goods using R&D and components as inputs, with cost data as follows: Components:

R&D:

Total costs of production = PC · QC = 200 Earnings of high-skilled labor = WH · HC = 50 Earnings of low-skilled labor = WL · LC = 50 Earnings of capital = R · KC = 100 Share of total costs paid to high-skilled labor = 50/200 = 25% Share of total costs paid to low-skilled labor = 50/200 = 25% Total costs of R&D = PR · QR = 200 Earnings of high-skilled labor = WH · HR = 60 Earnings of low-skilled labor = WL · LR = 40 Earnings of capital = R · KR = 40

Share of total costs paid to high-skilled labor = 60/200 = 30% Share of total costs paid to low-skilled labor = 40/200 = 20% a. In which factor(s) is components intensive? In which factor(s) is research intensive? Answer: Component production is intensive in the use of low-skilled labor, because the cost share of low-skilled labor in components (25%) exceeds the cost share of low-skilled labor in R&D (25%). Similarly, R&D is intensive in the use of high-skilled labor, because the cost share of high-skilled labor in R&D (30%) exceeds the cost share of high-skilled labor in components (20%). Capital is used more intensive in components (50%) than in R&D (20%). b. Suppose that due to the opening of trade, the relative price of R&D increases, ∆PR/PR = 10%, whereas the price of components stays unchanged, ∆PC/PC = 0. Calculate the change in the relative wage of high-skilled and low-skilled labor. Answer: Following the same hint that was given for Problem 4, we end up with the following two equations:  ∆WH   50   ∆WL   50  0  =   +  , for components  WH   200   WL   200   ∆WH   60   ∆WL   40  8%  =   +  , for R&D  WH   200   WL   200 

It follows that ∆WH/WH = 80% and ∆WL/WL = –80%. The wage for low-skilled labor falls by 80% and that of high-skilled labor increases by 80%, when the price of R&D rises by 10%. c. What has happened to the relative wage of high-skilled/low-skilled labor? How does this result compare to Problem 4, and explain why it is similar or different. Answer: With the wage for high-skilled labor going up, and the wage for lowskilled labor going down, it follows that the relative wage of high-skilled labor (WH/WL) also rises. Equivalently, the relative wage of low-skilled labor, which is (WL/WH), falls. The change in the relative wages is the same as what we found in Problem 4, because a fall in the relative price of components or a rise in the relative price of R&D has the same effects: to benefit high-skilled labor. Wage changes found in this problem are larger because the cost shares in the two activities are more similar than those in Problem 4. 6. Read the following excerpt, and using what you have learned in this chapter, discuss how offshoring creates opportunities for the countries involved. Sudhakar Shenoy, chief executive of Information Management Consultants (IMC) in Reston, makes an effective pitch for offshoring. Several years ago IMC saw a market developing for software that would allow biotech companies to make better and faster use of the new human genome

research. Doing it here, Shenoy calculated, would cost several million dollars, which he figured would have priced the product too high for most customers. But by having a small group of engineers at IMC’s Indian subsidiary do much of the coding work, he was able to bring the project in at $500,000. The result: IMC now has a thriving line of business in bioinformatics, with major clients and a growing payroll of six-figure PhDs here. And there are more engineers than ever—six here for every one in India. But that’s only part of the good-news story. In Pune, where IMC’s Indian operations are located, an airport under construction will require lots of U.S. engineering, design and electronics. At the same time, IMC’s Indian engineers, who earned annual salaries of $3,500 a decade ago, now command up to $12,000—enough to buy all manner of imported consumer goods. Source: Excerpted from Steven Pearlstein, “Still Short of the Offshoring Ideal,” Washington Post, March 12, 2004. Answer: By offshoring software in India, IMC is able to pass the cost savings to biotech companies researching the human genome. Moreover, the derived demand from Indian engineers by successful companies like IMC contributes to higher salaries for the local talents. In addition, the need for reliable infrastructure resulting from a growing economy boosted by companies such as IMC has led to the demand for U.S. engineering, design, and electronics. 7. The quote from the 2004 Economic Report o f the President at the beginning of the chapter generated a lot of controversy that year. The chairman of the Council of Economic Advisers, N. Gregory Mankiw, made the following additional comments in a speech while presenting the report: “Outsourcing is just a new way of doing international trade. More things are tradable than were tradable in the past, and that’s a good thing.” Those statements quickly led to reactions from both Democratic and Republican members of Congress. Tom Daschle, then the Democratic Senate minority leader, said, “If this is the administration’s position, they owe an apology to every worker in America.” Dennis Hastert, then Republican Speaker of the House, said, “Outsourcing can be a problem for American workers and the American economy.” John Kerry, the 2004 Democratic presidential candidate, referred to businesses that offshored as “Benedict Arnold corporations.” In response, Mankiw clarified his earlier comments: “My lack of clarity left the wrong impression that I praised the loss of U.S. jobs.” You might feel that these statements just represented a squabble between politicians trying to score points during a presidential campaign. Statements about outsourcing and offshoring are made during many presidential campaigns, including in 2016 when Donald Trump said that he’s “never eating another Oreo again” because its parent company is “closing a factory in Chicago and they’re moving to Mexico.” With all this media attention, it is worth trying to sort out who gains and who loses from offshoring. a.

Why does Mankiw say that “outsourcing is a good thing”? Who is it good for in the United States? Are there overall gains for the United States? Explain with a diagram. Answer: Mankiw says that offshoring is “a good thing” because there are overall

gains from the trade of production activities relative to autarky. As seen in Figure 7-10, both countries benefit by specializing in certain production activities and offshoring others. Trade in production activities allows for higher levels of output employing the same amount of domestic inputs. However, within each country these gains may not be spread evenly across workers of different skill levels, as changes in the number of tasks offshored lead to changes in the relative wage of high-skilled workers. b. Later in this chapter, Paul Samuelson is quoted as saying that there is no necessary surplus of winning over losings” due to offshoring. Use Figure 7-12 to carefully explain why Samuelson says this. Answer: Samuelson points out that loss due to offshoring may occur as a result of the deterioration in a country’s terms of trade. That is, from one offshoring equilibrium to another there are not necessarily gains since an increase in the relative price of a production activity hurts the importer of that activity. Of note, though, gains from offshoring are always greater than the situation with no-trade. c. Go online to find out whether Nabisco still produces Oreo cookies in the United States, how many jobs are being moved to Mexico, and why. 8. In Figure 7-14, we saw that a fall in the relative price of components leads to an increase in the amount of components imported but that the amount of R&D exported from Home does not necessarily increase. To explore this further, complete the following: a. Let the relative price of components continue to fall in Figure 7-14, and show in a graph what happens to the equilibrium point on the isoquant for the final good. Answer: As the relative price of components continues to fall, the use of components in the final good increases. Imports of components increase as the equilibrium production point moves out to the flatter portion of the final good isoquant, and the level of final good output increases (but at a diminishing rate due to diminishing returns in production). See the following figure.

b. Now draw another graph that has the relative price of components on the vertical axis and the imports of components on the horizontal axis. Start at the no-trade relative price of components, where imports are zero. Then label the various world relative prices of components on the vertical axis, and graph the quantity of imports at each price. Can we be sure that the import demand curve slopes downward? Answer: As the relative price of components decreases from the Home autarky level, Home components imports as well as the final goods produced increase. As long as incremental components are still useful in final good production, components imports will increase as their relative price decreases, which is guaranteed by the shape of the isoquants. See the following figure.

c. Now draw a new graph that has the relative price of R&D on the vertical axis and

the exports of R&D on the horizontal axis. Start at the no-trade relative price of R&D, where exports are zero. Then label the various world relative prices of R&D on the vertical axis, and graph the quantity of exports at each price. When the relative price of R&D is high enough, what do you notice about the export supply curve? Answer: See the following figure:

As the relative price of R&D increases from its autarky level, Home specializes further in R&D services and exports increase. However, for a sufficiently high relative price, import demand in the rest of the world diminishes as countries abroad substitute components for R&D in final good production. As a result, as Home approaches full specialization in R&D, exports of that activity approach zero. 9. Why might it be relatively easier for developing country like India to export service activities through offshoring than to participate in the global economy by producing manufacturing components? Answer: Because offshoring of manufactures involves the trade of intermediate inputs across several borders, there is an extra cost associated with transporting the goods. Therefore, a country must have good infrastructures such as developed roadways to participate in the global economy. In India, for example, communications technology developed rapidly, whereas transportation developed more slowly, which allowed the South Asian country to partake in service offshoring. The wages of educated workers are much lower in India than in the United States. India also has a proficiency in the English language, which is a necessity for service activities. 10. It is widely noted that even though China is the favored destination for manufacturing

offshoring, it is far behind India in the business of offshored services. What differences between these two countries might account for this causal observation? Answer: Although wages are also low in India, because of its weak transportation infrastructure, it is unable to successfully compete against China in manufacturing offshoring. However, it has an advantage over China in service offshoring because the country has developed an advanced communication infrastructure. Moreover, as a former British colony, India has a proficiency in the English language. The workforce in India is well educated and highly skilled in information technology. In addition, Tarun Khanna, a professor at the Harvard Business School, notes that India has a thriving entrepreneurial effort unhampered by government bureaucracy, unlike China (McKinsey Quarterly, 2004). This includes a low level of government intervention in the Indian capital markets and no regulations in industries such as software. 11. Chinese hourly manufacturing wages have increased by 12% per year on average since 2001, which is much higher than wage growth in developed or other developing countries. How will this wage growth in China affect its ability to serve as an offshoring location? Answer: This is an open question. Example answers are listed below. The direct impact of rising wage in China is that it decreases China’s ability to serve as an offshoring location, as firms from developed regions no longer benefit from the advantage of low cost in China. In response, these firms may re-offshore the production to countries with lower cost or even bring the offshored jobs back to their home countries. On the other hand, wage increase in China also implies a rise in Chinese demand. It could stimulate firms to sell more to China and expand their production scale, which may increase the demand of offshoring and offshoring more jobs to China.

8 Import Tariffs and Quotas Under Perfect Competition 1. At the opening of this chapter, we referred to the events of May 1995, when the United States considered putting tariffs on imports of luxury cars from Japan. Specifically, on May 16, 1995, U.S. Trade Representative Mickey Kantor announced that the United States would impose trade sanctions against Japan, targeting 13 Japanese import vehicles for 100% tariffs valued at $5.9 billion annually. Those targeted vehicles included all Lexus models and several Acura and Infiniti models. To determine how U.S. interest rates reacted to this announcement, use the FRED database at: https://research.stlouisfed.org/fred2/. a. Search for “Interest rate on US treasury bills,” and choose the 3-Month Treasury Bill: Secondary Market Rate, Weekly. Adjust the graph to see what happened to the interest rate in the week including May 16, 1995. How does this movement in the interest rate compare with neighboring weeks? Answer: The interest rate in the week including May 16, 1995, is higher, compared with those in the neighboring weeks. b. What type of retaliation by the government of Japan for the proposed tariff can explain this change in interest rates? Answer: The Japanese government might target U.S. imports such as aircraft and computers for retaliatory sanctions, which might include imposing retaliatory tariffs. c. About one month later, President Clinton announced that the two countries had reached an agreement, which ended the threat of the tariffs being imposed. What happened to the interest rate during the month of June? Answer: The interest rate went down in June, after the threat of tariffs had been removed. 2. The following questions refer to Side Bar: Key Provisions of the GATT. a. If the United States applies a tariff to a particular product (e.g., steel) imported from one country, what is the implication for its steel tariffs applied to all other countries according to the “most favored nation” principle? Answer: The MFN principle levels the playing field among countries with regard to any “advantage, favour, privilege or immunity granted by any contracting party to any product. . .” Thus, if the United States removed a tariff on steel imports from a particular country, it would necessarily have to remove it for the other GATT countries. Thus MFN treatment would prevent the application of a steel tariff to certain countries whereas others had lower or no tariffs. Conversely, a uniform tariff on steel imports from all countries alike would not violate the MFN principle. b. Is Article XXIV an exception to most favored nation treatment? Explain why or why not. Answer: Article XXIV allows for the creation of customs unions and free-trade areas. By definition, these contradict the MFN principle: Trade barriers are lowered within the area or union without a corresponding decrease in barriers to outside countries. Despite this violation of the MFN principle, RTAs are permitted because the removal of trade barriers among expanding groups of

countries is one way to achieve freer trade worldwide. c. Under the GATT articles, instead of a tariff, can a country impose a quota (quantitative restriction) on the number of goods imported? What has been one exception to this rule in practice? Answer: Article XI expressly prohibits the application of quantitative restrictions by any GATT country to any product. The MFA was a notable exception in practice; it allowed Canada, the United States, and Europe to restrict the amount of textiles and apparel products that were imported from garmentproducing countries. Article XIX’s clause also allows countries to temporarily restrain their imports of certain products if the domestic producers face serious injury. After the expiration of MFA in 2005, both the United States and the European Union established new quotas against imports of textiles from China for another three years. 3. Consider a small country applying a tariff t to imports of a good like that represented in Figure 8-5. a. Suppose that the country decides to reduce its tariff to t′. Redraw the graphs for the Home and import markets and illustrate this change. What happens to the quantity of goods produced at Home and their price? What happens to the quantity of imports? Answer: The reduction of the tariff, and corresponding decrease in domestic price in the small country, leads to a reduction in domestic production (to S3) and an increase in domestic quantity demanded (to D3). The result is an increase in imports (to M3). The price that Home consumers pay also drops from PW + t to PW + t′. See the following figure.

b. Are there gains or losses to domestic consumer surplus due to the reduction in tariff? Are there gains or losses to domestic producer surplus due to the reduction in tariff? How is government revenue affected by the policy change? Illustrate these on your graphs. Answer:

When tariff drops from t to t′ Rise in consumer surplus: +(a + b + c + d) Fall in producer surplus: −a Change in government revenue: (g + i) − c Change in total surplus: b + d + g + i Consumer surplus increases because consumers now buy a greater quantity of products at a lower price. Domestic producer surplus, on the other hand, decreases because Home producers sell a smaller quantity of products at a lower price. Government revenue changes by area (g + i − c). Notice that the tariff revenue does not necessarily decrease when the tariff is lowered because, although the tax per import is less, the amount of imports has increased. c. What is the overall gain or loss in welfare due to the policy change? Answer: Compared with free trade, the national DWL when applying tariff rate t is area (b + d + f + g + i + j). Compared with free trade, the DWL under tariff rate t′ is area (f + j). So when the tariff rate drops from t to t′, the national DWL is reduced by the area (b + d + g + i). 4. Consider a large country applying a tariff t to imports of a good like that represented in Figure 8-9. a. How does the export supply curve in panel (b) compare with that in the smallcountry case? Explain why these are different. Answer: The export supply curve is upward-sloping in the large-country case (it was horizontal in the small-country case). In the small-country case, a horizontal export supply curve means that the supply of exports from the rest of the world is infinitely elastic. This corresponds to the price taking assumption in perfect competition. In contrast, an upward-sloping export supply curve means that the price of exports from the rest of the world responds when the large country changes its import demand. For instance, if the large-country importer applies a tariff that decreases its demand for imports, the price charged by foreign exporters falls. b. Explain how the tariff affects the price paid by consumers in the importing country, and the price received by producers in the exporting country. Use graphs to illustrate how the prices are affected if (i) the export supply curve is very elastic (flat) or (ii) the export supply curve is inelastic (steep). Answer:

Refer to Figure 8-5: In the small-country case (flat export supply curve), a tariff increases the amount that consumers pay by exactly the amount of the tariff, and foreign exporters are paid the original world price PW; the difference is collected by the domestic government as tax revenue. Refer to Figure 8-9: With an upwardsloping export supply curve (in the large-country case) foreign exporters reduce their price due to a tariff; that is, foreign exporters receive less than they did prior to the tariff. Domestic consumers pay more than before, but by less than the full amount of the tariff. Again, the difference between what consumers pay and what Foreign exporters receive is the amount of the tariff t collected by the domestic government. In the large-country case, the incidence of the tariff is shared by domestic consumers and foreign producers. Moreover, a steeper foreign export supply curve implies that foreign exporters absorb more of the price increase due to the tariff. 5. Consider a large country applying a tariff t to imports of a good like that represented in Figure 8-9. How does the size of the terms-of-trade gain compare with the size of the deadweight loss when (i) the tariff is very small and (ii) the tariff is very large? Use graphs to illustrate your answer. Answer:

As the size of the tariff increases from t to t′, the export supply curve shifts upward by more, M2 decreases (relative to M3), and the size of the triangle with area b + d increases relative to rectangle e. That is, consumer deadweight losses get larger relative to terms-of-trade gains due to the tariff. We can interpret this as meaning that for small tariffs the welfare gains from terms-of-trade improvements outweigh consumer deadweight losses, but the opposite is true for tariffs that are sufficiently large. 6. a. If the foreign export supply is perfectly elastic, what is the optimal tariff Home should apply to increase welfare? Explain. Answer: This is the small-country case. Lowering the foreign export price will reduce export quantity to zero. Because the incidence of the tariff is shouldered completely by consumers and there is no terms-of-trade gain to applying a tariff, the optimal tariff is zero. b. If the foreign export supply is less than perfectly elastic, what is the formula for the optimal tariff Home should apply to increase welfare? Answer: This is the large-country case. The optimal tariff is determined as: , where E*x is the Foreign export supply elasticity. c. What happens to Home’s welfare if it applies a tariff higher than the optimal tariff? Answer: For a tariff higher than the optimal tariff, welfare declines because deadweight losses increasingly outweigh terms-of-trade gains. For a sufficiently high tariff, welfare can go as low as the autarky level. Work It Out Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly. a. Tariff of t in a small country corresponding to the quantity of imports M b. Tariff of t in a large country corresponding to the same quantity of imports M c. Tariff of t′ in a large country corresponding to the quantity of imports M′ > M Answer: For the same quantity of imports M, Home welfare is greater in the largecountry case relative to the small-country case because (assuming an optimal tariff) the terms-of-trade gain partially offsets the deadweight losses due to the tariff; thus, a < b for sure. A larger quantity of imports implies that t′ < t. There is no definite answer as to whether b > c or b < c. As shown in the graph, in Case 1: If t′ < t < t*, then a < c < b.

In Case 2: If t* < t′ < t, then a < b < c. In Case 3: If t′ < t* < t, then more cases can be discussed.

7. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly.

a. Tariff of t in a small country corresponding to the quantity of imports M b. Quota with the same imports M in a small country, with quota licenses distributed to Home firms and no rent seeking c. Quota of M in a small country with quota licenses auctioned to Home firms d. Quota of M in a small country with the quota given to the exporting firms e. Quota of M in a small country with quota licenses distributed to rent-seeking Home firms Answer: d = e, a = b = c. Refer to Figure 8-11, under cases a, b, and c; Home DWL = −(b + d); under cases d and e: Home DWL = −(b + c + d). A tariff t corresponding to imports M, and a quota on M units of import corresponding to tariff t are equivalent in terms of welfare so long as proceeds from quota rents remain in the Home country and are not squandered by rent-seeking activities: a = b = c. When quota rents are either given away to Foreign firms or are squandered completely by Home firms seeking access to rents, Home welfare diminishes by an equal amount (the amount of the quota rents): d = e, a = b = c. 8. Why did President George W. Bush suspend the U.S. tariffs on steel 17 months ahead of schedule? Answer: The threat of a tariff war from the European Union, Brazil, China, Japan, South Korea, New Zealand, Norway, and Switzerland in response to the U.S. steel tariff led President Bush to suspend the import tax earlier than the initial three-year schedule. 9. What provision of U.S. trade law was used by President Barack Obama to apply a tariff on tires imported from China? Does this provision make it easier or harder to apply a tariff than Section 201? Answer: President Obama used Section 421 to apply the tariff on imports of tires from China. Section 421, which is a China-specific safeguard provision, is easier to apply than Section 201 because it requires a lower level of injury to a U.S. industry. To apply safeguard tariffs under Section 421, the U.S. International Trade Commission (ITC) needs only find that rising imports from China are a “significant cause of material injury, or threat of material injury, to the domestic industry.” To impose a tariff under Section 201, the U.S. ITC must find that increased imports are the most important cause of material injury. 10. No U.S. tire producers joined in the request for the tariff on tires in 2009. Rather, the petition for a tariff on tires imported from China was brought by the United Steelworkers of America, the union who represents workers in the tire industry. Why did major tire manufacturers operating in the United States, like Goodyear, Michelin, Cooper, and Bridgestone, not support the tariff? Answer: Tire manufacturers operating in the United States did not support the tariff because many of them already manufacture tires in China. Of the 10 manufacturers operating in the United States, seven also produce tires in China through FDI or outsourcing, so a tariff on tires imported from China would make it more costly for them to produce in China.

11. Suppose Home is a small country. Use the graphs below to answer the questions.

a. Calculate Home consumer surplus and producer surplus in the absence of trade. Answer: Consumer surplus without trade: Producer surplus without trade: 1 1 CS = · 5 · (14 − 9) PS = · 5 · (9 − 4) 2 2 CS = 12.5 PS = 12.5 b. Now suppose that Home engages in trade and faces the world price, P* = $6. Determine the consumer and producer surplus under free trade. Does Home benefit from trade? Explain. Answer: Consumer surplus under free trade: Producer surplus under free trade: 1 1 CS = · 8 · (14 − 6) PS = · 2 · (6 − 4) 2 2 CS = 32 PS = 2 Total surplus under free trade: TS = CS + PS TS = 32 + 2 = 34

Total surplus without trade: TS = 12.5 + 12.5 = 25

Therefore, Home is better off with trade because total surplus increases by 9 (i.e., total surplus under trade is 34). c. Concerned about the welfare of the local producers, the Home government imposes a tariff in the amount of $2 (i.e., t = $2). Determine the net effect of the tariff on the Home economy. Answer: Consumer surplus with tariff: Producer surplus with tariff: 1 1 CS = · 6 · (14 − 8) PS = · 4 · (8 − 4) 2 2 CS = 18 PS = 8 Government revenue with tariff:

Government revenue = (6 − 4) · (8 − 6) Government revenue = 4 Total surplus = CS + PS + government revenue = 18 + 8 + 4 = 30 Fall in consumer surplus: −14 Rise in producer surplus: +6 Rise in government revenue: +4 Net effect on Home welfare: −4 The net effect of Home welfare is −4. 12. Refer to the graphs in Problem 11. Suppose that instead of a tariff, Home applies an import quota limiting the amount foreign can sell to 2 units. a. Determine the net effect of import quota on the Home economy if the quota licenses are allocated to local producers. Answer: An import quota of 2 units has the same net effect on Home welfare as an equivalent tariff of $2 when the quota licenses are allocated to local producers as long as the firms do not participate in rent-seeking activities. Fall in consumer surplus: −14 Rise in producer surplus: +6 Quota rents earned at Home: +4 Net effect on Home welfare: −4

b. Calculate the net effect of the import quota on Home welfare if the quota rents are earned by foreign exporters. Answer: Fall in consumer surplus: −14 Rise in producer surplus: +6 Net effect on Home welfare: −8 c. How do your answers to parts (a) and (b) compare with part (c) of Problem 11? Answer: With an import quota of 2 units the net effect on Home welfare is

equivalent to that of a tariff of $2 (i.e., the net effect on Home welfare is −4) when the quota licenses are allocated to local producers. If the quota rents are earned by foreign exporters, Home welfare falls further so that the net effect is −8. The answer to part (a) (−4) equals part (c) of Problem 11, but the DWL in part (b) (−8) exceeds part (c) of Problem 11 (−4). 13. Consider a small country applying a tariff t such as in Figure 8-5. Instead of a tariff on all units imported, however, we will suppose that the tariff applies only to imports in excess of some quota amount M′ (which is less than the total imports). This is called a “tariff-rate quota” (TRQ) and is commonly used on agricultural goods, including sugar imports into the United States. a. Redraw Figure 8-5, introducing the quota amount M′. Remember that the tariff applies only to imports in excess of this amount. With this in mind, what is the rectangle of tariff revenue collected? What is the rectangle of quota rents? Explain briefly what quota rents mean in this scenario. Answer: Refer to the following figure: For the small-country tariff case, tariff revenue equals the tariff per import multiplied by the amount of imports. In panel (b), this is represented by the rectangle a + b. With the TRQ, only M′M2 imports are subject to the tariff. Therefore, the government collects t · M′M2 = b. Because the new domestic price is P* + t, someone has the ability to buy (or produce) abroad for P* and sell domestically for P* + t. This differential is called quota rents and can be represented by the amount of the quota multiplied by the difference between domestic and world price: t · M′ = a. b. How does the use of a TRQ rather than a tariff at the same rate affect Home welfare? How does the TRQ, as compared with a tariff at the same rate, affect Foreign welfare? Does it depend on who gets the quota rents?

Answer: If the quota rents stay at Home and are not squandered by rent seekers (i.e., they are collected by the government through auction or given to Home firms), then Home’s welfare is the same as under a tariff. However, if quota rents

are given to the foreign country, then Home’s welfare is less than under a tariff. By analogous reasoning, if quota rents stay at Home, then Foreign’s welfare is unchanged, whereas if quota rents are sent abroad, then Foreign’s welfare is higher. c. Based on your answer to (b), why do you think TRQs are used quite often? Answer: Given that the Foreign country’s welfare decreases with the addition of a tariff on its exports to Home (i.e., it sells fewer goods to Home at the same price or less than before), Home can make the situation more politically palatable to Foreign by implementing a TRQ and giving away the quota rents to foreign firms. 14. Consider the following hypothetical information pertaining to a country’s imports, consumption, and production of T-shirts following the removal of the MFA quota: With MFA World price ($/shirt) Domestic price ($/shirt) Domestic consumption (million shirts/year) Domestic production (million shirts/year) Imports (million shirts/year)

2.00 3.00 200

Without MFA (Free Trade) 2.00 2.00 250

150

100

150

a. Graph the effects of the quota removal on domestic consumption and production. Answer: With the quota removal, domestic consumption increases from 200 units to 250 units, whereas production decreases from 150 units to 100 units. b. Determine the gain in consumer surplus from the removal of the quota.

Answer: Consumers gain by the areas a + b + c + d with the removal of the quota, which is 225 = 1/2 · (200 + 250) · (3 − 2).

c. Determine the loss in producer surplus from the removal of the quota. Answer: Producers lose by the area a with the removal of the quota. d. Calculate the quota rents that were earned under the quota. Answer: The quota rents are represented by the area c, which is 25 = (3 − 2.00) · (200 − 150). e. Determine how much the country has gained from removal of the quota. Answer: Assume quota rents are wasted in Home, then the gain to the country from the removal of the quota is area (b + c + d), which is 25 + 50 + 25 = 100. 1

area b = · (150 − 100) · (3.00 − 2.00) 2 area b = 25 area c = (3 − 2) · (200 − 150) area c = 50 1 area d = · (250 − 200) · (3.00 − 2.00) 2 area d = 25 15. Suppose that a producer in China is constrained by the MFA to sell a certain number of shirts, regardless of the type of shirt. For a T-shirt selling for $2.00 under free trade, the MFA quota leads to an increase in price to $3.00. For a dress shirt selling for $10.00, the MFA will also lead to an increase in price. With MFA Domestic price of t-shirt ($/shirt) Domestic price of dress shirt ($/shirt)

3.00 ?

Without MFA (Free Trade) 2.00 10.00

a. Suppose that the MFA leads to an increase in the price of dress shirts from $10 to $12. Will the producer be willing to export both T-shirts and dress shirts? (Remember that only a fixed number of shirts can be exported, but of any type.) Explain why or why not. Answer: The MFA is tantamount to an increase in rents on each of the imports falling under the quota amount. Because Chinese shirt producers receive these rents in the form of higher prices, they will export only the product which has the greatest price increase. As such, they will export only dress shirts. b. For the producer to be willing to sell both T-shirts and dress shirts, what must be the price of dress shirts under the MFA? Answer: The producer will sell both types of shirts if the price increase of dress shirts is also $1; the price of dress shirts under the MFA is $11. c. Based on your answer to part (b), calculate the price of dress shirts relative to T-

shirts before and after the MFA. What has happened to the relative price due to the MFA? Answer: The relative price of dress shirts before the MFA is $10/$2 = 5. The relative price of dress shirts under the MFA is $11/$3 = 3.7. The relative price of dress shirts has declined. d. Based on your answer to part (c), what will happen to the relative demand in the United States for dress shirts versus T-shirts from this producer due to the MFA? Answer: Relative demand for dress shirts will increase. e. Thinking now of the total export bundle of this producer, does the MFA lead to quality upgrading or downgrading? How about the removal of the MFA? Answer: Using price as an indicator for quality, then the MFA causes quality upgrading. Demand for dress shirts increases relative to T-shirts, causing the relative amount of dress shirts in the Chinese exporter’s bundle to increase. Removing the MFA would drive up the relative price of dress shirts with converse effects on the average quality of the exporter’s bundle.

9 Import Tariffs and Quotas Under Imperfect Competition 1. Figures A, B, and C are taken from a paper by Chad Bown: “The Pattern of Antidumping and Other Types of Contingent Protection” (World Bank, PREM Notes No. 144, October 21, 2009), and updated from Chad Brown, 2012, “Global Antidumping Database,” available at www.brandeis.edu/~cbown/global_ad/.

a. Figure A shows the number of newly initiated trade remedy investigations including safeguard (SF), and China safeguard (CSF), antidumping (AD), and countervailing duty (CVD) (a countervailing duty is used when foreign firms receive a subsidy from their government, and then the CVD prevents them from charging lower prices in the importing country). Each bar shows the number of new cases in each quarter of the year (Q1, Q2, etc.) for 2007 through Q1 of 2012. The number of cases is graphed separately for developing countries and developed countries. What does this graph tell us about what has happened to the number of such cases since 2007? What might have caused this pattern? Answer: From the second quarter of 2007 onward the number of newly initiated trade remedy investigations increased nearly every quarter. The number reaches its peak in 2009 Q3, and the number of requests for protection throughout 2009 to 2012 is much higher than the number of requests that took place before 2008. The majority of all new requests are filed by developing economies, but this trend starts to change, when the number of new requests filed by developed economies increased in 2011. One of many possible explanations is that the global recession, which started in late 2007, has led to greater protectionism, as we have discussed in this chapter.

b. Figure B shows the number of safeguard (SF) tariff initiations by WTO members. Since 1995 what three years saw the largest numbers of safeguards? What might explain these increases? (Hint: consider the U.S. business cycle over these years.) Answer: The three years that saw the largest number of safeguard tariff initiations by WTO members were 2000, 2002, and 2009. One possible explanation of the spikes in safeguard tariff initiations in 2002 and 2009 is that the United States was in a recession in both the early 2000s and again in 2009. c. According to Figure B, year 2002 had the most safeguards actions by WTO members. How many actions were started that year, and what U.S. safeguard case that year was discussed in this chapter? Answer: In 2002, a total of 35 safeguard actions were initiated by WTO members. That year, President Bush imposed safeguard tariffs on steel imports under Section 201 of the U.S. Trade Act of 1974 (as was discussed in Chapter 8). As we can see from Figure B, 10 of the 35 tariffs imposed in 2002 were related to steel products.

d. Figure C shows the number of newly initiated antidumping (AD) investigations, for quarters of the year from 2007 through Q1 of 2012. Compare the number of cases in this graph with Figure A, which included safeguard (SF), China safeguard (CSF), antidumping (AD), and countervailing duty (CVD). What can

you conclude about the total number of SF, CSF, and CVD cases as compared to the number of AD cases? Answer: As we can see from Figures A and C, the majority of the safeguard investigations are antidumping investigations. In the third quarter of 2009 there were 44 newly initiated trade remedy investigations, of which 37 were antidumping investigations. The trend is similar for all quarters reported. This trend makes sense given that in the United States antidumping duties require a lower burden of proof, and are more often imposed as a result (as in Table 8-1). 2. Figure 9-1 shows the Home no-trade equilibrium under perfect competition (with the price PC) and under monopoly (with the price PM). In this problem, we compare the welfare of Home consumers in these two situations. a. Under perfect competition, with the price PC, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus). Answer: Refer to Figure 9-1: Consumer surplus is the area under the demand curve D and above the market price, and producer surplus is the area above the marginal cost curve MC and below the market price. Under perfect competition, consumer surplus is PCBPD, where PD is the intersection of the demand curve with the vertical axis. Producer surplus is PCBPMC, where PMC is the intersection of the marginal cost curve with the vertical axis. Total surplus is thus represented by the triangle PMCBPD. b. Under monopoly, with the price PM, label the consumer surplus triangle. Answer: Refer to Figure 9-1: Consumer surplus is the triangle PMAPD. c. Producer surplus is the same as the profits earned by the monopolist. To measure this, label the point in Figure 9-1 where the MR curve intersects MC at point B′. For selling the units between zero and QM, marginal costs rise along the MC curve, up to B′. The monopolist earns the difference between the price PM and MC for each unit sold. Label the difference between the price and the MC curve as producer surplus, or profits. Answer: Refer to the following figure: Producer surplus is represented by the trapezoid PMAB′ PMC.

d. Outline the area of total Home surplus with a Home monopoly. Answer: Refer to the figure from part (c): Total surplus is represented by the trapezoid PDAB′PMC. e. Compare your answer with parts (a) and (d), and outline what the difference between these two areas is. What is this difference called and why? Answer: Refer to the figure from part (c): This is called the deadweight loss due to monopoly, and is represented by the triangle ABB′. It is called a deadweight loss because it is a loss that is not gained by any other party. Work It Out Figure 9-2 shows the free-trade equilibrium under perfect competition and under monopoly (both with the price PW). In this problem, we compare the welfare of Home consumers in the no-trade situation and under free trade. a. Under perfect competition, with the price PW, label the triangle of consumer surplus and the triangle of producer surplus. Outline the area of total Home surplus (the sum of consumer surplus and producer surplus). Answer: Refer to the following figure: The free-trade equilibrium under perfect competition has a Home consumer surplus of PDB′PW, and a producer surplus of PWBPMC.

b. Based on your answer to part (a) in this problem and part (a) of the last problem, outline the area of gains from free trade under perfect competition. Answer: Refer to the figure from part (a): Gains from trade are represented by the shaded triangle. c. Under monopoly, still with the price PW, again label the triangle of consumer surplus and the triangle of producer surplus. Answer: Refer to the figure from part (a): The free-trade equilibrium under monopoly has a Home consumer surplus of PDB′PW, and a producer surplus of PWBPMC. This is identical to the free-trade surplus under perfect competition. d. Based on your answer to part (c) in this problem and part (d) of the last problem, outline the area of gains from free trade under Home monopoly. Answer: Refer to the following figure: Gains from trade are represented by the shaded area.

e. Compare your answer to parts (b) and (d). That is, which area of gains from trade is higher and why? Answer: The area representing gains from trade is larger in part (d) than in part (b). This is because the opening of trade in the monopoly case eliminates the monopolist’s ability to charge a price higher than the perfectly competitive price. As such, trade additionally eliminates the deadweight loss associated with monopoly, making gains from trade higher. 3. Rank the following in ascending order of Home welfare and justify your answers. If two items are equivalent, indicate this accordingly. a. Tariff t in a small country with perfect competition b. Tariff t in a small country with a Home monopoly c. Quota with the same imports M in a small country, with a Home monopoly d. Tariff t in a country facing a Foreign monopoly Answer: c < a = b < d. As shown in Problem 2, a small country with free trade has equivalent levels of welfare under either perfect competition or monopoly. Adding a tariff in either case reduces welfare due to the deadweight loss associated with the tariff, but does not reintroduce any additional deadweight losses due to monopoly. Thus, a = b. A quota in a country with a monopoly maintains the market power of the monopolist, and the deadweight loss due to monopoly is additive to the deadweight loss due to the quota, such that: c < a = b. Finally, a tariff with a Foreign monopoly can actually increase welfare if the terms-of-trade gain is greater than the deadweight loss, and if so, a = b < d. 4. Refer to the prices of Japanese automobile imports under the VER (Figure 9-5) and answer the following: a. What component of the price of imported automobiles from Japan rose the most during the period 1980 to 1985? Answer: Quality improvements increased the price of Japanese cars by the most

over that period. b. Sketch how Figures 9-5 and 9-6 might have looked if the United States had applied a tariff to Japanese auto imports instead of the VER (with the same level of imports). In words, discuss how the import prices and U.S. prices might have compared under a tariff and the VER. Answer: Under a percentage (i.e., ad valorem) tariff, the relative price of highquality automobiles is unchanged relative to low-quality automobiles. Therefore, you would not expect the average quality level of imports to change as a result of the tariff. Therefore, Figure 9-5 would not show the large increase in quality of Japanese imports. For U.S. producers, the tariff would not enable them to raise their prices as much as they did. Therefore, Figure 9-6 would not show the large increase in the price of American small cars. c. Which policy—a tariff or the VER—would have been least costly to U.S. consumers? Answer: Because the tariff would lead to a smaller increase in the prices of small American cars, it would be less costly than the VER. With a tariff, the Home monopolist can no longer exercise its monopoly power because of foreign competition. But with a VER, the Home monopolist is the only producer to sell in the Home market once the quota limit is reached. So it can still exercise its market power. Hence, the quota leads to higher costs for Home consumers than the tariff. 5. In this problem, we analyze the effects of an import quota applied by a country facing a Foreign monopolist. In Figure 9-7, suppose that the Home country applies an import quota of X2, meaning that the Foreign firm cannot sell any more than that amount. a. To achieve exports sales of X2, what is the highest price that the Foreign firm can charge? Answer: Refer to the following figure: To achieve export sales of exactly X2, the Foreign monopolist would charge P2.

b. At the price you have identified in part (a), what is the Home consumer surplus? Answer: Refer to the figure in part (a): Home consumer surplus is represented by the shaded triangle with area b. c. Compare the consumer surplus you identify in part (b) with the consumer surplus under free trade. Therefore, outline in Figure 9-7 the Home losses due to the quota. Hint: Remember that there is no Home firm, so you do not need to take into account Home producer surplus or tariff revenue. Assume that quota rents go to Foreign firms. Answer: Refer to the figure in part (a): Consumer surplus under free trade is a triangle with area b + c + d. Under a quota, consumer surplus decreases by c + d. The Home welfare loss due to the quota is thus area c + d. d. Based on your answer to (c), which has the greater loss to the Home country—a tariff or a quota, leading to the same level of sales X2 by the Foreign firm? Answer: Because there is no terms-of-trade gain associated with the quota, welfare is lower under a quota regime relative to a tariff regime. 6. Suppose that the demand curve for a good is represented by the straight line P = 20 − 2Q Answer: In italics in the following chart. Quantity

Price

0 1 2 3

20 18 16 14

Total Revenue 0 18 32 42

Marginal Revenue NA 18 14 10

4 5 6 7 8 9 10

12 10 8 6 4 2 0

48 50 48 42 32 18 0

6 2 −2 −6 −10 −14 −18

a. Draw a graph containing both the demand curve and marginal revenue curve. Answer:

b. Is the marginal revenue curve a straight line as well? What is the slope of the marginal revenue curve? How does that slope compare with that of the demand curve? Answer: Like the demand curve, the marginal revenue curve is a straight line. The slope of the marginal revenue curve is −4 and the slope of the demand curve is −2. Thus, the slope of the marginal revenue curve is twice as steep as the demand curve. c. Does the marginal revenue curve contain negative values over the specified range of quantities? Explain why or why not. Answer: Over the specified range of quantities, the marginal revenue curve does contain negative values. After the fifth unit sold, to sell a sixth, the fall in price on every unit sold causes revenue to decrease, yielding a negative marginal revenue. 7. Consider the case of a Foreign monopoly with no Home production, shown in Figure 9-7. Starting from free trade at point A, consider a $5 tariff applied by the Home government.

a. If the demand curve is linear, as in Problem 6, what is the shape of the marginal revenue curve? Answer: The shape of the marginal revenue curve is also linear, but twice as steep. b. How much does the tariff-inclusive Home price increase because of the tariff, and how much does the net-of-tariff price received by the Foreign firm fall? Answer: Because the marginal revenue curve is steeper than the demand curve (twice as steep in this case), the vertical increase along the marginal revenue curve of $5, reflecting the tariff, is twice as much as the corresponding vertical increase along the demand curve. Thus, the Home tariff-inclusive price increases by $2.5 and the net-of-tariff Foreign price decreases by $2.5. c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrate under what conditions, if any, there is an increase in Home welfare. Answer: Refer to the following figure: The tariff decreases Home consumer surplus by the area c + d, increases government revenue by the area c, and improves Home’s terms of trade by the area e. Thus if e exceeds d, there is an overall welfare gain from the tariff.

8. Suppose the Home firm is considering whether to enter the Foreign market. Assume that the Home firm has the following costs and demand: Fixed costs = $100 Marginal costs = $15 per unit Local price = $30 Local quantity = 40 Export price = $25 Export quantity = 20 a. Calculate the firm’s total costs from selling only in the local market. Answer:

Total costs = Variable Costs + Fixed Costs = $15 · 40 + $100 = $700 b. What is the firm’s average cost from selling only in the local market? Answer: Average costs = Total Costs/Local Quantity = $700/40 = $17.5 c. Calculate the firm’s profit from selling only in the local market. Answer: Profit = Revenue – Total Costs = $30 · 40 – $700 = $500 d. Should the Home firm enter the Foreign market? Briefly explain why. Answer: The firm should enter the Foreign market because it would be earning an additional $200. The firm is able to earn the extra profit because the exporting price, $25, which is higher than the marginal cost of $15. e. Calculate the firm’s profit from selling to both markets. Answer: Profit = Revenue – Variable Costs – Fixed Costs = ($30 · 40 + $25 · 20) - $15 · 60 - $100 = $700 f. Is the Home firm dumping? Briefly explain. Answer: The firm is dumping because its export price ($25) is lower than its local price ($30). 9. Suppose that in response to a threatened antidumping duty of t, the Foreign monopoly raises its price by the amount t. a. Illustrate the losses for the Home country. Answer: Refer to the following figure: The threat of an antidumping duty causes the Foreign firm to increase its price by t = P2 − P1. Consumer surplus decreases by the area a + b.

b. How do these losses compare with the losses from a safeguard tariff of the amount t, applied by the Home country against the Foreign monopolist? Answer: A safeguard tariff would differ in two ways: (1) The Home government would collect revenue on imports and (2) there would be a terms-of-trade gain for the Home country because the incidence of the tariff would be shared by the Foreign monopolist. Both differences reduce the amount of Home welfare loss under a tariff relative to a threatened antidumping duty. c. In view of your answers to (a) and (b), why are antidumping cases filed so often? Answer: Despite their higher welfare costs, antidumping tariffs have a higher likelihood of being implemented under U.S. trade law than do safeguard tariffs. So antidumping cases are more frequently used as a strategic trade policy. Because Home producers benefit due to higher prices when there is even a threat of an antidumping duty, they have an incentive to apply for this kind of protection. 10. Why is it necessary to use a market failure to justify the use of infant industry protection? Answer: If all markets are working perfectly, there is no reason a potentially successful fledgling industry cannot survive without government intervention. Let us consider the two justifications for using an infant industry tariff. The first is that the industry will learn over time, which will drive down its average costs to the point at which it is competitive; if credit markets were working perfectly, that industry could borrow against future profitability to keep it in business until that time. The second justification explicitly assumes a market imperfection: A positive externality in production implies that the socially optimal level of infant industry output is above that determined by the market equilibrium. 11. What is a positive externality? Explain the argument of knowledge spillovers as a potential reason for infant industry protection. Answer: Positive externality exists when the increase in production by one firm generates benefits to other firms by lowering industry costs. By imposing the tariff, the government could nurture the infant industry because the increase in output allows the firms to reduce their future costs by learning from one another. Without the protection, each firm on its own would lack the incentive to invest in learning through increasing its current production. 12. If infant industry protection is justified, is it better for the Home country to use a tariff or a quota, and why? Answer: To the extent that the Home infant industry has market power, it is better to use a tariff rather than a quota. The infant industry calculus weighs the benefits of future producer surplus against current deadweight losses due to protection. Because deadweight losses are greater under a quota due to maintaining Home market power, infant industry protection has a better chance of being worthwhile by using a tariff.

10 Export Policies in Resource-Based and High-Technology Industries 1. In Figure 10-8 we showed the value of Chinese exports of rare earth minerals, along with their average price and quantity sold, in three categories of exports. The source for the data in Figure 10-8 is the China Customs Statistics. In this problem, you will check the value of imports of rare earth minerals for the United States. To answer this question, you can access the Trade Stats Express database at the International Trade Administration, U.S. Department of Commerce. (If you are using this textbook in another country, you should try to answer this question using the customs statistics for your own country.) a. Start at the webpage http://www.trade.gov/, and find Trade Stats Express under the Data & Analysis tab. Choose National Trade Data, and Product Profiles of U.S. Merchandise Trade with a Selected Market. Select China as a Trade Partner, and select Imports. On this page, categories of goods are identified by their Harmonized System (HS) codes. The HS codes for products can have 2 digits or 4 digits; you should choose 4 digits. Change the product from HS-total to the HS code 28, and display the U.S. imports from China within this HS code. You will find two 4-digit HS codes that include RARE_EARTH within their names. What are these codes? Graph the value of U.S. imports in each of these codes for 2007– 15. What do you notice about the graphs during the key period 2010–12? Answer: These codes are: 2805--ALKALI METALS ETC; RARE-EARTH METALS ETC 2846--RARE-EARTH METAL COMPOUNDS OF YTTRIUM OR SCANDIUM

U.S. Import of HS4 2846 (million USD) 469.6183 98 173.5715 66127.8254 122.2604 116.0249 81.26722 3592.49021 72.012045167.6302648 2 3 8 1 2007 2008 2009 2010 2011 2012 2013 2014 2015

U.S. Import of HS4 2805 (million USD) 77.63378 4 30.86916 6 17.44078 15.14605 14.67060 6 2 5

40.89819 6 22.82599 21.94342 4 15.29724 6 2

2007 2008 2009 2010 2011 2012 2013 2014 2015

From the above graphs, we observe the gross import of these two products peaks in 2010 during period 2010–12. b. Subtract the U.S. imports for these two HS codes from the total imports within HS 28 (as shown at the top of the display), and call this the remaining imports. Then graph the remaining imports over 2007–15. How does the shape of this graph compare with those in part (a)? Answer:

U.S. Import of Other HS 28 (million USD) 1845.131 019 1422.730 1498.837 1361.622 1330.984057 74 1155.087 469 134 1092.257 518 959 872.1884 792.0343 24 2007 2008 2009 2010 2011 2012 2013 2014 2015

The graph of the remaining imports looks similar to those in part (a), reaching the maximum in 2011. However, the change is not as fluctuating as the import change of HS2846 and HS2805. c. Now inspect the value of imports for all other 4-digit HS codes within this category of HS 28. Are there any other codes that show a marked increase during 2011, with a reduction after that? What are these other codes? By inspection of their names, could these other codes include rare earth minerals? Answer: A similar pattern can also be found in other products. HS 2825--HYDRAZINE ETC, OTH INORG BASES; METAL OXIDES ETC HS 2839--SILICATES; COMMERCIAL ALKALI METAL SILICATES Based on the names, these products are likely to contain rare earth minerals.

2. Describe the impact of each of the following goals from the Hong Kong WTO meeting on (i) domestic prices and welfare of the country taking the action and (ii) world prices and welfare for the partner countries. a. Elimination of agriculture export subsidies Answer: Refer to Figure 10-1; if agriculture export subsidies are eliminated in a small exporter, then its domestic prices will decrease from PW + s to PW, and the associated deadweight loss of area b + d will disappear. The world prices will not be affected, as the partner countries still pay the world price PW. Refer to Figure 10-2; if agriculture export subsidies are removed in a large exporter, then the domestic price drops from P* + s to PW, whereas the world price paid by the partner countries increases from P* to PW. The agriculture exporter enjoys a term-of-trade and welfare gain, whereas the consumer surplus of its trading partners lowers as a result of paying higher prices. b. Reduction of agricultural tariffs Answer: Agriculture tariffs in a small country also have the effect of raising

domestic prices. Tariffs in a large country have the effect of raising domestic prices and lowering foreign prices. As such, any country abolishing an agricultural tariff would decrease domestic prices. The associated decrease in deadweight loss would increase domestic welfare in a small country, but welfare would decrease in a large country because of worsening terms of trade. In the rest of the world, exporters no longer suffer a terms-of-trade loss from the import country’s tariff regime; therefore, they export at higher prices and have higher welfare after tariffs are abolished. Foreign importers, on the other hand, suffer a terms-of-trade and welfare loss. c. Duty-free, quota-free access for 97% of goods originating in the world’s least developed countries. Answer: As in part (b), removing tariffs and quotas decreases prices and deadweight losses in the import market. The exporting LDCs will benefit because of higher export prices and will enjoy a gain in welfare as a result. Conversely, importing LDCs will face higher world prices and have lower welfare. The welfare calculation for other poor countries not included among the LDCs is more complex because trade may be diverted to the LDCs from lower-cost producers that are still subject to trade barriers. Work It Out Consider a large country with export subsidies in place for agriculture. Suppose the country changes its policy and decides to cut its subsidies in half. a. Are there gains or losses to the large country, or is it ambiguous? What is the impact on domestic prices for agriculture and on the world price?

Answer: There are unambiguous gains to the large exporting country. Not only

do deadweight losses decrease but terms-of-trade losses due to the subsidy are also diminished. As shown in panel (b), cutting subsidies in half will shift the 1 export supply curve up to X − s. So the world price of agriculture increases from *

P to P ′, and domestic prices for agriculture drops from P* + s to P*′ + s. There 2 are unambiguous gains to the large exporting country. Consumer surplus increases and the Home terms-of-trade improves. Deadweight losses unambiguously decrease, as represented by the reduced area of −(b + d + e).

b. Suppose a small food-importing country abroad responds to the lowered subsidies by lowering its tariffs on agriculture by the same amount. Are there gains or losses to the small country, or is it ambiguous? Explain. Answer: From our discussion of small-country tariffs, the optimal tariff level is zero. Hence, the small food importer gains from reducing its tariff as deadweight losses decrease. If a small food-importing country responds to lower its tariffs on agriculture by the same amount, then the Home export supply curve shifts back to X − s as in the figure again. Foreign consumers still enjoy the low price of P*, and the consumer surplus benefit a gain of area e′. c. Suppose a large food-importing country abroad reciprocates by lowering its tariffs on agricultural goods by the same amount. Are there gains or losses to this large country, or is it ambiguous? Explain. Answer: From our discussion of large-country tariffs, the optimal tariff level is positive because (for small tariffs) terms-of-trade gains exceed deadweight losses. If we assume that the tariff-reducing country was previously at its optimal tariff, then welfare is reduced by cutting its tariff, but there is still an overall gain from the bilateral reduction in subsidies and tariffs. Because terms-of-trade gains for one party are terms-of-trade losses for the other, we can measure the net overall benefits of bilateral trade barrier removal as the reduction in both countries’ deadweight losses. 3. Suppose Home is a small exporter of wheat. At the world price of $100 per ton, Home growers export 20 tons. Now suppose the Home government decides to support its domestic producer with an export subsidy of $40 per ton. Use the following figure to answer these questions.

a. What is the quantity exported under free trade and with the export subsidy? Answer: Under the export subsidy, exports increase to 40 tons (= 50 − 10), whereas the amount exported under free trade is 20 tons (= 40 − 20). b. Calculate the effect of the export subsidy on consumer surplus, producer surplus, and government revenue. Answer: Refer to the following figure: Consumer surplus decreases by the area a + b: 1 ∆CS = −(40 · 10) − (40 · 10) 2 = −600 Producer surplus increases by the area a + b + c: 1 ∆PS = (40 · 40) + 2 (40 · 10) = 1,800 Government revenue decreases by the area b + c + d: ∆Gov. Rev. = −(40 · 40) = −1,600

c. Calculate the overall net effect of the export subsidy on Home welfare. Answer: The net effect on Home welfare is the sum of changes in consumer surplus, producer surplus, and government revenue: −400. This is the total deadweight loss of the subsidy, equal to the area b + d. 4. Refer to Problem 3. Rather than a small exporter of wheat, suppose that Home is a large country. Continue to assume that the free-trade world price is $100 per ton and that the Home government provides the domestic producer with an export subsidy in the amount of $40 per ton. Because of the export subsidy, the local price increases to $120, while the foreign market price declines to $80 per ton. Use the following figure to answer these questions.

a. Relative to the small-country case, why does the new domestic price increase by

less than the amount of the subsidy? Answer: The new domestic price increases by less in the large-country case because part of the subsidy is offset by decreasing world prices. This reflects a downward-sloping import demand curve in the rest of the world. b. Calculate the effect of the export subsidy on consumer surplus, producer surplus, and government revenue. Answer: Refer to the following figure: Consumer surplus decreases by the area a + b: 1 ∆CS = −(20 · 15) − 2 (20 · 5) = −350 Producer surplus increases by the area a + b + c: 1 ∆PS = (20 · 40) + (20 · 5) 2 = 850 Government revenue decreases by the area b + c + d + e: ∆Gov. Rev. = −(40 · 30) = −1,200

c. Calculate the overall net effect of the export subsidy on Home welfare. Is the large country better or worse off compared with the small country with the export subsidy? Explain. Answer: The net decrease in welfare due to the subsidy is −700(= −350 + 850 − 1,200). This is a larger loss than in the small country because of Home’s terms-oftrade loss. 5. Refer to Problem 3. Suppose Home is a small exporter of wheat. At the world price of $100 per ton, Home growers export 20 tons. But rather than an export subsidy, suppose the Home government provides its domestic producer with a production subsidy of $40 per ton. Use the following figure to answer these questions.

a. What is the quantity exported with the production subsidy? Answer: Under the production subsidy, Home’s quantity supplied increases from 40 to 50 tons. Because the Home consumer price (and hence quantity demanded) remains unchanged at $100 because of a production subsidy, the entire increase in production is exported. The new quantity exported is 30 tons (= 50 − 20). b. Calculate the effect of the production subsidy on consumer surplus, producer surplus, and government revenue. Answer: Refer to the following figure: Consumer surplus is unaffected: ∆CS =0 Producer surplus increases by the area a + b + c: 1 ∆PS = (40 · 40) + (40 · 10) 2 = 1,800 Government revenue decreases by the area a + b + c + d: ∆Gov. Rev. = −(40 · 50) = −2,000

c. Calculate the overall net effect of the production subsidy on Home welfare. Is the cost of the production subsidy more or less than the cost of the export subsidy for the small country? Explain. Answer: The net decrease in Home welfare is −200 (area a). The welfare cost of a production subsidy is less than the welfare cost of an export subsidy because there is no deadweight loss associated with consumer behavior (i.e., area b is not a deadweight loss as in the export subsidy case). The reason for this difference is that under a production subsidy, the Home domestic price does not increase; firms are paid the subsidy whether they export or not, so they do not charge the domestic consumers more than Foreign consumers. 6. Explain why the WTO is more concerned with the use of direct export subsidies than production subsidies in achieving the same level of domestic support. Answer: Direct export subsidies create a consumption loss and a production loss, whereas production subsidies generate only the latter. By targeting principle, production subsidy generates a lower deadweight loss and therefore is a better policy instrument than the export subsidy. 7. Boeing and Airbus are the world’s only major producers of large wide-bodied aircrafts. But the increasing cost of fuel and the changing demand in the airline industry increases the need for smaller regional jets. Suppose that both firms must decide whether they will produce a smaller plane. We will assume that Boeing has a slight cost advantage over Airbus in both large and small planes, as shown in the payoff matrix below (in millions of U.S. dollars). Assume that each producer chooses to produce only large, only small, or no planes at all.

a. What is the Nash equilibrium of this game? Answer: Recall that the idea of Nash equilibrium is that each firm must make its own best decision, taking as a given each possible outcome from the other firm. In this case, if Boeing produces large planes, Airbus’s optimal reaction is to choose to produce small planes: Its payoff is 125 million (vs. 0 million and −5 million for the other alternatives). Similarly, if Airbus produces small planes, Boeing’s optimal reaction is to produce large planes: Its payoff is 115 million. In this case, considering both firms’ optimal reaction to each choice of its rival yields two Nash equilibria: where one firm produces large planes and the other firm produces small planes. b. Are there multiple equilibria? If so, explain why. Hint: Guess at an equilibrium and then check whether either firm would want to change its action, given the action of the other firm. Remember that Boeing can change only its own action, which means moving up or down a column, and Airbus can change only its own action, which means moving back or forth on a row. Answer: Starting from either of the equilibria illustrated in the payoff matrix below, it is possible to verify that no action on the part of any player can improve its payoff. It also makes intuitive sense why these two equilibria are the best possible outcomes for the firms because they make both firms a monopolist in different aircraft markets.

8. Refer to Problem 7. Now suppose the European government wants Airbus to be the sole producer in the lucrative small-aircraft market. Then answer the following: a. What is the minimum amount of subsidy that Airbus must receive when it produces small aircraft to ensure that outcome as the unique Nash equilibrium? Answer: Assume that the firms start out in the Nash equilibrium wherein Boeing produces small planes and Airbus produces large planes. To get Airbus to change production to small planes, the European Union needs the small-plane payoff to exceed the large-plane payoff; that is, small-plane payoff must increase by at least 101 million. Given a subsidy of 101 million, Airbus switches production to small planes; then, Boeing switches production to large planes because it is no longer Boeing’s optimal response to produce small planes at the same time as Airbus. The new unique Nash equilibrium (with subsidy) is for Airbus to produce small planes and Boeing to produce large planes. b. Is it worthwhile for the European government to undertake this subsidy? Answer: When judging whether a policy is worth it, we consider its implication for welfare (i.e., its effect on the sum of producer surplus, consumer surplus, and government revenue). In this case, changing from the production of large planes to the production of small planes increases Airbus producer surplus increases by 25 as profits increase from 100 to 125. Producers also collect 101 from the government in the form of a subsidy. Government expenditure increases (revenue decreases) by 101 to finance the subsidy. Adding up, overall welfare increases by 25. It is worth it. 9. Here we examine the effects of domestic sales taxes on the market for exports, as an example of the “targeting principle.” For example, in the domestic market, there are heavy taxes on the purchase of cigarettes. Meanwhile, the United States has several very large cigarette companies that export their products abroad.

a. What is the effect of the sales tax on the quantity of cigarette exports from the United States? Hint: Your answer should parallel the case of production subsidies but for a consumption tax instead. Answer: Refer to the following figure: Putting a tax on consumers is analogous to providing a subsidy to domestic production. Just as the subsidy boosted the amount of domestic production, leaving quantity demanded unchanged, so does a consumption tax reduce domestic quantity demanded while leaving domestic production unchanged. The resulting level of exports is higher than it was before the consumption tax. Intuitively, a cigarette tax reduces the domestic demand. Given a fixed cigarette production, the surplus output will be sold overseas as excess exports.

b. How does the change in exports, if any, due to the sales tax compare with the effect of an export subsidy on cigarettes? Answer: Exports under the consumption tax are higher than under free trade, although not as high as they would be under an export-subsidy regime. Under an export-subsidy regime, exports increase due to a drop in quantity demanded and an increase in domestic production. Consumption tax, however, won’t generate an incentive to increase domestic production. 10. Refer to Problem 9. Based on your answer there, would foreign countries have a reason to object to the use of a sales tax on cigarettes by the United States? Based on your knowledge of the GATT/WTO provisions (see Side Bar: Key Provisions of the GATT in Chapter 8), are foreign countries entitled to object to the use of such a tax? Answer: A consumption tax, like a production subsidy, increases the quantity exported, but not by as much as an export subsidy. In this sense, foreign countries

have equal basis to object to either production subsidies or consumer taxes as less damaging types of export subsidies. However, because they do not cause as big a change in export volume, in many cases (such as the negotiations at the Hong Kong WTO meetings) production subsidies are not dealt with as strongly or urgently as export subsidies. In Article XVI of the GATT, a subsidy is defined as: “. . . any form of income or price support, which operates directly or indirectly to increase exports of any product from, or to reduce imports of any product into, its territory.” A consumption tax as outlined above would fit into this broad definition, and WTO member countries would be entitled to request that these subsidies be limited. 11. To improve national welfare, a large country would do better to implement an export subsidy rather than an import tariff. Is this true or false? Explain why. Answer: A large country may improve its terms of trade with an import tariff, leading to an overall gain in national welfare. With an export subsidy, the additional amount exported drives down the world price so that the large country is worse off. Refer to Figure 10-2 in the text. Home welfare suffers a loss, −(b + d + e), when implementing export subsidy. Namely, the country’s welfare is hurt by an export subsidy due to the loss in terms of trade. Thus, the statement is false. 12. Who gains and who loses when governments in Europe and the United States provide subsidies to Airbus and Boeing? Answer: The clear winners are foreign consumers of Boeing and Airbus because the subsidies lower the price they pay. The governments in Europe and the United States incur the cost of the subsidy. The aircraft manufacturers gain from lowering the cost of production with the subsidy. The net effect on European and American welfare depends on whether the government assistance successfully affects competition such that the profit earned by the aircraft manufacturers exceeds the cost of the subsidy to the government. 13. Provide reasons for countries to use export subsidies. Does your answer depend on whether firms compete under perfect or imperfect competition? Answer: Export subsidies are used to encourage the domestic firm to produce more in a particular industry. Moreover, subsidies may be offered if there is a potential for the positive externality from the production of the product to spill over to the rest of the economy. Under imperfect competition, a government can use subsidies to strategically affect the interaction between firms and increase the profits of its own domestic firm.

11 International Agreements: Trade, Labor, and the Environment 1. In Application: The Trans-Pacific Partnership, we summarized some of the provisions of TPP and the views of consumer and environmental groups. The text of the TPP agreement is available at: https://ustr.gov/tpp/#text. We will use that text to dig deeper into the agreement a. Consider the provisions listed in the Application, namely: Dispute Settlement, Intellectual Property Protection, Labor Rights, Environmental Protection, and Tariffs and Rules of Origin. For each of these items, which chapter of TPP would cover that topic? Answer: Dispute Settlement (Chapter 28), Intellectual Property Protection (Chapter 18), Labor Rights (Chapter 19), Environmental Protection (Chapter 20), and Tariffs (Chapter 6) and Rules of Origin (Chapter 3) b. For each of these topics, scan the chapter to find the sections that discuss the key features of each provision, as we have summarized it in the Application. List the sentence(s) of the TPP text that support our summary in the Application. In addition, describe one other feature of each provision that we have not mentioned in the Application. Answer: Answers will vary. Dispute Settlement: Disputes are settled not through the regular court system but by an arbitration board that is set up according to the rules of each free-trade agreement. One example text can refer to “…At the request of a disputing Party or on its own initiative, the panel may seek information and technical advice from any person or body that it deems appropriate, provided that the disputing Parties so agree and subject to such terms and conditions as the disputing Parties may agree. The disputing Parties shall have an opportunity to comment on any information or advice so obtained….” c. In the Application we also discussed the views of consumer and environmental groups. For each provision, go online to find a statement from one group that either supports or does not support each provision, and include these statements with your answer. Answer: Answers will vary. Environmental and consumer groups are opposed to the Trans-Pacific Partnership on some highlighted issues. For example, environmentalists worry that TPP will lead to a rise in harmful environmental pollutants as manufacturing operations move to countries with relatively low environmental standards. On the other hand, consumers worry that TPP will cause job losses and decrease wages in the United States. 2. a. How is a customs union different from a free-trade area? Provide examples of each. Answer: Members of a customs union impose a uniform tariff on countries outside the agreement, unlike that of a free-trade area, where each country maintains its own separate import tax on nonmembers. Examples of a customs

union and a free-trade area are the European Union and NAFTA, respectively. b. Why do some economists prefer multilateral trade agreements over regional trade agreements? Answer: Regional trade agreements may lead to trade diversion when a member country imports from another member with higher production costs rather than continuing to purchase the product from its former supplier that has a lower cost of production but is a nonmember. Unlike a regional trade agreement, a multilateral trade agreement has a larger membership such that the tariff reductions are enjoyed by more countries so that trade diversion may be avoided. 3. Figure 11-2 shows the tariff game between Home and Foreign, both large countries. a. Redraw the payoff matrix for a game between a large and small country. Answer:

b. What is/are the Nash equilibrium/equilibria, assuming that the large country applies an optimal tariff? Answer: There is a unique Nash equilibrium in which the large country applies a tariff and the small country does not. The large country applies an optimal tariff for a net welfare gain, whereas the small country does not apply a tariff because its optimal tariff is always zero. c. What does your answer to (b) tell you about the role of the WTO in a situation like this? Answer: The WTO has a more difficult job in this case because only the small country stands to gain by switching to the free-trade equilibrium (whereas the large country stands to lose). The WTO still has a role, though, by assembling groups of small countries that collectively act as a large country in international trade markets. A large group of small countries would provide a much more compelling reason for the large country to remove its tariffs because every party would then be escaping the prisoner’s dilemma outcome, as discussed in the

chapter. Work It Out Consider the following variation of Table 11-1 for the U.S. semiconductor market:

From Canada, before NAFTA From Asia, before NAFTA From Canada, after NAFTA From Asia, after NAFTA From the United States

0% $45 $40 $43 $40 $46

U.S. Tariff 8% 16% $W $52.2 $X $Y $Z $Z $X $Y $46 $46

a. Fill in the values for W, X, Y, and Z. Answer: W = $48.6, X = $45.36, Y = $48.72, Z = $45 b. Suppose that before NAFTA, the United States had a 16% tariff on imported semiconductors. Which country supplied the U.S. market? Is it the lowest-cost producer? Answer: Before NAFTA, the least expensive option for U.S. consumers was the domestically produced semiconductor, even though the lowest-cost producer (netof-tariff) was Asia. c. After NAFTA, who supplies the U.S. market? Has either trade creation or diversion occurred because of NAFTA? Explain. Answer: After NAFTA, the least cost producer becomes Canada. Semiconductors from Canada now cost $45, which is less than the cost of producing domestically, $46. This is an example of trade creation. d. Now suppose that before NAFTA, the United States had an 8% tariff on imported semiconductors. Then repeat parts (b) and (c). Answer: If the United States had an 8% tariff, before NAFTA the United States would import semiconductors from Asia at a cost of $45.36. In this case, Asia is the lowest-cost producer, so despite the tariff, the most efficient country is producing semiconductors. However, after NAFTA, the cost of importing semiconductors from Canada drops from $48.6 to $45, which means that the United States will stop importing from Asia (the lowest-cost producers). This is an example of trade diversion. e. In addition to the assumptions made in (d), consider the effect of an increase in high-technology investment in Canada due to NAFTA, allowing Canadian firms to develop better technology. As a result, three years after the initiation of NAFTA, Canadian firms can begin to sell their products to the United States for $40. What happens to the U.S. trade pattern three years after NAFTA? Has either trade creation or diversion occurred because of NAFTA? Explain.

Answer: Refer to Figure 11-3. With better technology, marginal cost of production significantly reduces for Canada so that its supply curve shifts out. Now Canada will fully replace Asia as the supplier of semiconductors to the United States. The United States will lose its tariff revenue from Asia, but it experiences a net gain in consumer surplus. Canadian producer surplus rises because it is exporting more. This case combines elements of trade diversion (Canada replaces Asia) and trade creation (Canada is exporting more to the United States) and the extent of trade creation for Canada exceeds the amount of trade diversion. 4. Assume that Thailand and India are potential trading partners of China. Thailand is a member of ASEAN but India is not. Suppose the import price of textiles from India (PIndia) is 50 per unit under free trade and is subject to a 20% tariff. As of January 1, 2010, China and Thailand entered into the China–ASEAN free-trade area, eliminating tariffs on Thai imports. Use the following figure to answer the questions:

a. Before the China–ASEAN free-trade area, how much does China import from each trading partner? What is the import price? Calculate the tariff revenue. Answer: China imports 10 units from Thailand and 50 units from India. The tariff-inclusive price is 60 and the net-of-tariff price is 50. The tariff revenue is 600. b. After the China–ASEAN free-trade area, how much does China import from each trade partner? What is the import price? What is the total tariff revenue of China? Answer: After the China–ASEAN free-trade agreement, the relevant supply curve for Thailand is SThailand because it is able to sell to China duty-free. Without the tariff, imports from Thailand increase to 40 units with price remaining constant at PIndia + t ($60). Price is unchanged because the rise in production results from increasing marginal costs as given along Thailand’s supply curve. Although China continues to import from India, the amount purchased has

decreased to 20 units = (60 − 40). The total tariff revenue of China is now 200 = [area d = $(60 − 50) × (60 − 40)]. c. Based on your answer to part (b), what is the impact of the China–ASEAN freetrade area on the welfare of China? Answer: China is paying the same import price as before, but has lost the tariff revenue on the 30 units (area b + c) that it used to import from India and now imports from Thailand. In addition, it loses the tariff revenue on the 10 units (area a) that it imported from Thailand all along, so the total loss is (a + b + c) = 400. Therefore, China is worse off due to this trade diversion. d. What is the effect of the China–ASEAN free-trade area on the welfare of Thailand and India? Answer: India has a producer surplus loss because it is selling less yet still receives the same price as before (50 net of the tariff). Thailand has a rise in producer surplus of the amount (a + b) due to selling more to China, so Thailand is better off. But the gain for Thailand of (a + b) is less than the loss of tariff revenue for China, which is (a + b + c). e. The China-ASEAN agreement may lead to a similar one between China and India. How would this affect China’s imports from each country? What would be the effect on welfare in China, Thailand, and India if such an agreement was signed? Answer: If China and India sign a free-trade agreement, the relevant supply curves are SIndia and SThailand, which means trade diversion will be eliminated and production in Thailand will be restored to the pre–free-trade area levels. Now the price in China is $50 and the total demand has grown to 70 units, of which 10 units are from Thailand, and 60 units are from India. Welfare in China increases because consumer surplus has grown by the area (a + b + c + d + e) and tariff revenues decrease only by (d) so welfare has increased by (a + b +c + e). 5. Redraw the graph of trade diversion (Figure 11-3) with the S′Mex curve intersecting the MUS curve between points A and D. a. When the United States and Mexico join NAFTA, who supplies auto parts to the United States? Does the United States import a larger quantity of auto parts after NAFTA; that is, does trade creation occur? Answer: Because Mexico can now produce at a lower price than Asia with tariff, PMex < PAsia + t, U.S. consumers purchase only Mexican auto parts. At this lower price, U.S. consumers purchase a larger quantity (trade creation). b. What is the change in government revenue compared with before NAFTA? Answer: A tariff revenue loss of a + b + c + d. c. Is the United States better off for joining NAFTA? Answer: As shown in the graph, tax revenue for the States will reduce by (a + b +

c + d), but U.S. consumer surplus gains by area of trapezoid (PAsia + t, F, E, P + t′). Whether the United States gains as a whole depends on the comparison of these two areas. At point A, consumer surplus does not change and the United States is worse off by the amount of tax revenue loss, a + b + c + d. As the S′Mex curve moves rightward along the MUS curve, U.S. consumer surplus increases until it reaches the area a + b + c + d + e at point D, a net gain to the United States of area e. Therefore, at some point along MUS between A and D, the consumer surplus gains exactly equal the revenue losses; to the right of that point the United States is better off, and to the left of that point the United States is worse off.

6. Refer to the survey in Table 11-2 regarding consumers’ attitudes toward working conditions. a. Fill in the survey questions for yourself and at least five friends. Answer: Answers will vary. b. Average your results and compare them with those in Table 11-2. Are there any consistent differences in the answers from your friends and those in Table 11-2? Answer: Answers will vary. c. Do the answers from your friends show the following two characteristics? i. Many people are willing to pay at least a small amount to ensure good labor standards (or simply switch to an alternative with the same price), though relatively few are willing to pay a lot. ii. Individuals had to receive a higher discount to purchase a T-shirt made under poor conditions than they were willing to pay for a T-shirt made under good conditions. Explain whether these characteristics apply to your friends. Answer: Answers will vary.

7. Using Table 11-3, explain why environmentalists have “lost the battle but won the war” in their dealings with the WTO. Refer to specific WTO cases in your answer. Answer: In many instances, the WTO dispute settlement body has ruled against the party with an environmental grievance. For instance, in the tuna–dolphin case, the U.S. import ban was declared illegal, even though Mexican fisherman were not using dolphin-safe nets; in the shrimp–turtle case, the U.S. ban was again declared illegal even though some Asian shrimp boats were not using turtle-safe nets; in the gasoline case, the ban on Venezuelan and Brazilian oil was declared illegal, even though their gas contained more smog-causing chemicals; and in the biotech foods case, European bans on genetically modified organisms were declared illegal even though their human and environmental safety are subject to debate. However, despite these individual losses, these cases have significantly increased awareness of environmental issues and, in many cases, have led to environmentally friendly solutions. For instance, labeling conventions implemented for tuna have drastically reduced the number of fisherman using nets that are unsafe for dolphins. It is also worthwhile to note that the WTO has been increasingly siding with environmentalists in recent cases, such as the asbestos case in which public health, safety, and environmental concerns allowed France to ban imports of asbestos from Canada (despite unequal treatment of domestic firms). 8. Refer to Figure 11-4 when answering this question. a. Redraw Figure 11-4, panel (a), assuming that the production externality is positive so that the SMC curve lies below the supply curve. Label the area c that reflects the change in the cost of the externality when trade is opened. Is this area an additional social gain from free trade or an offsetting cost? Can you think of a real-world example of this case? b. Redraw Figure 11-4, panel (b), assuming that the consumption externality is positive so that the SMB curve lies above the demand curve. Label the area d that arises when trade is opened, and explain why this area is an additional social gain from free trade. (You can refer to the discussion of solar panels earlier in the chapter.) Answer:

(a) Positive Production Externality ΔCS +(a + b) ΔPS −a ΔPrivate gain +b ΔSocial loss of externality −c ΔTotal welfare b − c

(b) Positive Consumption Externality ΔCS +(a + b) ΔPS −a ΔPrivate gain +b ΔSocial gain of externality +d ΔTotal welfare b+d

a. As shown in panel (a), positive production externality lowers the social marginal cos. When trade is opened, the quantity supplied by the Home industry falls from Q0 to S1. Free trade reduces the positive externality at Home and leads to social loss, which is measured by the fall in production times the difference between the SMC and S curves, or the shaded area c. An example could be if a firm engaging in R&D reduces its output because of import competition, then it reduces the spill-over effects to the other firms, which leads to a social loss. b. In panel (b), positive consumption externality increases the social benefit of consumption and shifts up the SMB curve. For example, installing solar panels at home reduces the environment pollution from burning fossil fuels. Free trade increases Home consumption from Q0 to D1. This rise in consumption leads to an extra social gain, which is the shaded area d. It is the rise in the quantity consumed times the distance between the SMB and D curves. 9. Refer to following variations of the payoff matrix for the environmental game shown in Figure 11-7. In this problem, a number is assigned to represent the welfare level of each outcome for Home and Foreign. a. First, consider the case of global pollution, in which the government puts more weight on producer profits than consumer well-being when calculating welfare (this is so since a portion of consumer costs are borne by the other country). How can you tell that the government favors producers over consumers from the following payoff matrix? What is the Nash equilibrium for this environmental game? Is it a prisoner’s dilemma? Briefly explain.

Answer:

The welfare of producers is relatively important, which is evident from the payoff matrix because for either country there are always welfare gains to move from regulation to no regulation despite the fact that consumers are worse off. As such, each country has a best strategy not to regulate; therefore, the unique Nash equilibrium is in the bottom-right quadrant. This is a prisoner’s dilemma outcome because both countries would obtain higher welfare by simultaneously regulating. b. Next, consider the case of local pollution in which the government puts more weight on consumer well-being than producer profits when calculating welfare. How can you tell that the government favors consumers over producers from the

following payoff matrix? What is the Nash equilibrium for this environmental game? Is it a prisoner’s dilemma? Briefly explain.

Answer:

The welfare of consumers is relatively important, which is evident from the payoff matrix because for either country there are always welfare losses to move from regulation to no regulation, despite the fact that producers are better off. Furthermore, notice that each country’s welfare is independent of the other country’s choices because local pollution does not affect the other country. As such, each country has a best strategy to regulate; therefore, the unique Nash equilibrium is in the top-left quadrant. This is not a prisoner’s dilemma outcome because both countries obtain the highest possible welfare by simultaneously regulating.